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The editors of Fidelity Interactive Content Services (FICS) selected this content because it offers valuable information for investors.

Navigating pullbacks

Make sure you haven’t taken on too much risk during stock market rallies.

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Until recently, market volatility has been pretty hard to find, despite unsettling headlines from Washington, the threat of conflict with North Korea, and more.1 The latest pullback, including a record-setting single day point drop for the Dow on February 5, 2017, is a reminder of the reality of investing—that markets go up and down.

No one can predict the timing of corrections with certainty. What we do know is that they have historically been a normal part of investing. In fact, since 1920, the S&P 500® has experienced an average of three 5% corrections each year, a 10% correction once a year, and a 20% correction every three years. The last 5% correction happened in the summer of 2016, making this the longest run without a 5% price drop since the mid-1990s. So, chances are we are getting closer to the next correction, even if we don’t know when it will take place.

Fidelity’s director of global asset allocation research, Lisa Emsbo-Mattingly, says that while economic data looks strong and earnings have been solid, she is watching some signs in the credit cycle that suggest the late cycle could be coming.

“When everyone is looking at the sunny weather, I try to look for clouds,” says Emsbo-Mattingly. “I think we are between the mid and late phases of the business cycle, a time when the performance of different types of investments has been historically mixed. I think that means it’s not the time to abandon stocks, but it’s also not the time to take big bets the way you might early in the cycle.”

Here are three ideas you may want to consider to get ready for the next correction.

Get back to your plan

The time to consider how much of a loss you can handle isn’t during a correction. Rather, you should consider the appropriate risk level for your portfolio when you are looking at your long-term goals, and think clearly about your financial situation and emotional reaction to risk. If you haven’t created a plan, you should. If you have one, it may be worth checking in to see if your investments are still in line with that plan. If they are, you should be fine living through the ups and downs of the market. However, a recent analysis of Fidelity Personal Investing client accounts, primarily brokerage and IRA accounts, shows that the rising markets and investor behavior have combined to drive up stock holdings as a proportion of portfolios. Back in 2009, Fidelity investors overall had 52% of assets in stocks; by the end of 2016, Fidelity investors had 67% of assets in stocks—back to levels last seen just before the financial crisis.2 If your mix of investments is off track, consider rebalancing back to a more neutral positioning.

Look for hidden risk

For most long-term investors, there is no need to deviate from a solid investment plan just because you are concerned that market conditions might change. Still, it's important to make sure that the different pieces of your portfolio are going to play the roles you want them to play when conditions do change, which they eventually will.

For example, some investors may have taken on more risk in their portfolios in recent years by moving into lower-quality bonds or dividend stocks, in an attempt to generate additional yield. Compared to high-quality bonds, both dividend stocks and high-yield bonds have historically had higher volatility overall and higher correlation to the overall stock market. So if you are hoping your bond holdings will act as a shock absorber during times of volatility, it is worth reviewing your particular holdings to make sure they are positioned to play the role you hope they will.

Some stocks may contain more risk than others. For example, fund manager Matthew Friedman of the Fidelity Value Strategies Fund says that while he is finding pockets of opportunity, he thinks stocks overall are getting more expensive. As a result, he is positioning his fund with the potential of a downturn in mind.

“I've been making a concerted effort to avoid lower-quality companies that appear cheap in relation to the market by considering industry structure, long-term financial returns, and balance sheet for each company,” says Friedman. “If the market goes through a correction, these lower-quality firms’ earnings should decrease significantly and performance may suffer.”

Have an exit plan

While most investors who have a long-term plan probably don't need to make any portfolio changes in anticipation of a spike in market volatility, some more active investors may want to take action to prepare for a correction. That could mean anything from setting exit strategies on existing positions, using trailing stops, or tracking technical indicators for indications it is time to sell.

More active investors might also want to consider having a cash reserve, and creating a watch list of stocks to consider buying at certain price points, to prepare for buying stocks in the event of a downturn.

The bottom line

It has been about a year and a half since the market last experienced a 5% correction. While we don’t know when the next one will come, history shows that it eventually will. Fortunately, history also shows that the market recovers from corrections, and most sound investment strategies are built to withstand volatility. As a result, long-term investors should make sure they are sticking with their plan, and not taking on any hidden risk. 

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