Investors appear to be getting more worried about a possible stock market correction, as we've seen the VIX jump upwards over the past few weeks. More bad headlines are swirling about the fourth wave of the coronavirus pandemic, Fed tapering looks imminent, and the major stock indexes are still poking around their all-time highs.
All of the concern about how those things might impact Wall Street might prove unfounded — the economy could continue to chug along and corporate earnings may stay strong. That said, a market dip isn't out of the question. Fortunately, there's a playbook to help you navigate corrections without breaking a sweat.
Tip 1. Keep your cool and think long term
Stock market corrections are stressful, and it's natural to have an emotional reaction to them. Your nest egg is coming under attack, potentially jeopardizing your retirement or your kids' college funds. When share prices plunge, many people begin to doubt their investment strategies. A calm assessment of the new conditions is OK. Panic-triggered responses usually aren't.
Fear and doubt are natural, but you can't let them guide your financial decision-making at crucial moments. During such times, it's important to remember what led you to choose your investment strategy in the first place, and the investment thesis for each of the stocks you hold. Volatility happens, and every well-conceived portfolio should be constructed with the recognition that Wall Street will inevitably experience periodic downturns.
Corrections are part of a normally functioning stock market. They can even be considered healthy events, as they clear out excess speculation, exuberance, and over-aggressive valuations. The long-term trend of the U.S. stock market has always been upward. Since 1950, even during its worst stretches, the S&P 500 has never delivered negative returns over any 15-year period. It's been positive over almost every single 10-year span as well.
Giving in to fear and selling after a dip is exactly how you realize losses. Do everything you can to avoid that. Instead of cutting your losses with that fear-based strategy, you're most likely to instead miss out on the eventual rebound. Don't abandon your long-term investing plan just because of a rough patch that you already knew had to come sooner or later.
Tip 2. Review your investment allocation
While panic-selling during a downturn is a bad choice, when market conditions change, that is a good time to review your portfolio allocation to make sure that it's still aligned with your goals and risk tolerance. Shifting asset prices may have moved your allocation out of balance, so it might make sense to adjust exposures in recognition of that, and of the new economic outlook. Without making any drastic changes, you can tweak your portfolio within the framework of your overall strategy.
A stock market dip could also signal a volatile period with deeper corrections to come. Bonds and defensive stocks are effective tools for limiting downside risk during bear markets. If your portfolio is experiencing too much volatility due to a high exposure to cyclical and growth stocks, it might be a good time to reduce your risk profile. It's especially important for retirees to find the right balance. Without earned income, you might be tempted to sell off investments to free up cash to cover your living expenses. Instead, consider buying dividend stocks and investment-grade bonds that produce passive income regardless of their market prices.
Other people may be in the opposite situation, and need to open themselves up to more growth opportunities. If the stock market has plunged, that has probably reduced the percentage of your overall portfolio's value that comes from equities. High-flying growth stocks with aggressive valuations usually take the worst beatings early in bear markets. But those hard-hit stocks are often among the best performers when the market turns around, so make sure that your allocation isn't overly cautious after the damage has been done.
Regardless of your exact situation, keep yourself positioned for long-term gains with the appropriate amount of risk. On one hand, a stock market dip doesn't necessarily mean that more losses are imminent. On the other, yes, things could also get worse before they get better. Regardless, don't sell out of stocks entirely, and don't recklessly chase gains in an effort to recoup losses right away.
Tip 3. Buy more shares if you can
This is basically an extension of the above advice, but it goes beyond your investment portfolio. Once your investment allocation is straightened up, it's a good idea to review your investments in the context of your overall financial plan. A market correction means it will cost you less to buy shares in some of the worlds' greatest companies. It's like a sale on items that will (hopefully) eventually pay you back for buying them.
Do you have cash on the sidelines in CDs, a money market, or a savings account, waiting for opportunity to come knocking? Maybe an old cash-value insurance policy that's been growing slowly and steadily for years? If you have income security and an ample emergency fund, you might want to consider putting any excess cash you can find to work in stock market during the next dip. Don't overextend to invest — after all, the market might not be done dropping. However, the best stretches in the stock market have historically tended to follow soon after the worst ones. Stay calm, act rationally, and take advantage of the opportunities provided to you.
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