How to get ready for a stock market decline

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

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Key takeaways

  • Given the inevitability of market pullbacks, it's important to have an investment plan you can stick with through market ups and downs.
  • Active investors should think about exit strategies during market volatility.

After experiencing the first 10% correction earlier this year, US stocks are again flirting with all-time highs, driven upward by corporate earnings. But there are threats on the horizon, among them: escalating global trade tensions, rising short-term interest rates, relatively high stock valuations, and signs of moving into the late phase of the business cycle.

Could another pullback be around the corner?

Of course, no one can predict the timing of stock market 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 on average experienced a 5% pullback 3 times a year, a 10% correction once a year, and a 20% bear market decline every 3 years. So, chances are we could be getting closer to the next correction, even if we don't know exactly when it will take place.

Fidelity’s director of global asset allocation research, Lisa Emsbo-Mattingly, says that she is watching some signs in the credit cycle that suggest the late cycle could be coming.

“When most investors are enjoying the sunny weather, I try to keep an eye out for any 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 3 ideas you may want to consider to get ready for the next correction.

Stick 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 and if your plan continues to reflect your investment horizon, financial situation, and risk tolerance. If all that is so, you will likely be in better position to manage 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.* 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 from higher-quality bonds into lower-quality bonds offering more yield, or from defensive stocks to growth stocks. Compared to high-quality bonds, 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.”

Be prepared

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 stop loss orders, or tracking technical indicators for signs it could be 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 6 months since the market’s 10% correction earlier in the year. While we don’t know when the next market decline 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. 

Next steps to consider

Research Fidelity's managed accounts.

Explore ways to reach your goals.

Make sure your portfolio is in line with your plans.

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