Situation Analysis
Have a sound, long-term plan for investing. Don’t let emotions drive your investing decisions.

How Should You Prepare for the Next Market Downturn?

How Should You Prepare for the Next Market Downturn?

For investors, a plunging stock market can be horrific. Many are still reeling from the "COVID" crash in early 2020. But those who didn’t panic were quickly rewarded with not only a full market recovery but also a big lift to new market highs. This raises the questions of how long this roaring stock market can continue to defy gravity and whether investors should be preparing for another plunge.

When will the Next Market Downturn Occur?

As to the first question, no one can predict with any degree of certainty when the stock market will change direction. We know that investors who try to time the market typically underperform investors who stay the course, in large part because they often miss out on many of the best return days of the market, which tend to occur near market bottoms. We also know that we can expect another stock market crash. We just don’t know when.

So, if another market correction or crash is inevitable, how should investors be preparing, if at all? History tells us that market crashes occur about every eight years. History also tells us that, for every market crash, a market recovery follows that ultimately leads to new market highs. Historically, bull markets have lasted about nine years, whereas bear markets have lasted about 1.5 years. And, where the average loss in a bear market is -41%, the average total gain for bull markets is 480%. What that tells us is the real risk for investors is not a 41% bear market decline; it’s missing out on the next 480% gain in the market.

How Should Investors Prepare?

So, as to what investors should do to prepare for the next big market decline, the answer is probably nothing and just allow the markets to work. While a temporary market downturn may seem consequential at the time, it has little if any impact over ten, twenty, or thirty years of investment performance.

The best course of action to take today is to develop a sound, long-term investment strategy based on your specific objectives and risk profile. If your portfolio is properly diversified, it should be able to withstand the shock of short-term market declines on its way to generating positive long-term returns. The stock market has historically rewarded investors with the patience and discipline to stick with their long-term strategy.

Don’t Be Your Own Worst Enemy

The challenge for investors is not how they prepare for the next market decline; it’s how they react when it happens. The fear of losing money can drive investors to make costly decisions. It’s during market downturns where composure can prevent permanent losses. Here are three compelling reasons why you should not sell during a market downturn:

If You Don’t Sell it isn’t a Loss

When the market turns down sharply, investors’ "loss aversion" instincts take over. Many investors would rather sell their investments rather than watch their account balance evaporate. But it’s critical to keep in mind that the only way you can actually lose money is you sell and lock in the loss. That’s a permanent loss of capital. Just remember, when the market plunges, this too will pass.

You Can’t Time the Market

Then, if you stay out of the stock market until you think it’s safe to go back in, you are likely going to miss the biggest return days in the market’s recovery. To be successful at market timing by buying at the low and selling at the high points of the market, you have to be right twice, which is virtually impossible. The average market timer underperforms the S&P 500 by more than 3%. To do better, you would have to make the right decisions 75% of the time. It’s not surprising then that the average equity mutual fund investor unperformed the 20-year average return of the S&P 500 by nearly five percent, which a Dalbar study revealed to be the result of poor market timing decisions.

It’s Not Part of the Plan

The stock market is always going to fluctuate. There’s no getting around it. However, if you have a well-conceived investment plan and stay focused on your investment objectives, you don’t have to be concerned with short-term fluctuations. For investors with a ten- to twenty-year plus time horizon, a 30% market decline will show as nothing more than a blip on your long-term investment performance. A well-diversified portfolio with a mix of asset classes can help reduce volatility. Investors who have conviction in their investment plan are less likely to panic when the market turns against them.

Conclusion

One of the greatest investors of all time, Benjamin Graham, once said, "The investor’s chief problem – and his worst enemy – is likely to be himself." Graham went on to say, "In the end, how your investments behave is much less important than how you behave." Graham believed, along with many other legendary investors, that investing without a sound, long-term plan allows emotions to drive investing decisions. It’s emotions that cause investors to make costly behavioral mistakes, such as selling in a panic or trying to time the market, which invariably leads to poor outcomes.


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