3 Ways to Brace Your Portfolio and Sleep Easy in a Market Crash

The past few months have been unsettling for many investors as the markets have all been in negative territory, with the S&P 500 down about 6% year to date and the Nasdaq 100 down about 11% through Feb. 15. Some growth stocks have been down twice that amount or more in a swoon that began in late October/early November due to the most overvalued market we’ve seen since the dot-com bubble burst.

And the worst might not be over. Some analysts say the malaise, particularly with some growth stocks, should continue through the year, exacerbated by expected interest rate hikes.

If the market volatility and uncertainty are keeping you up at night, these three strategies may help you sleep a bit easier.

Image source: Getty Images.

1. Consider your risk tolerance and time horizon

There are three broad planks on which to build your investment portfolio: risk tolerance/time horizon, asset allocation, and diversification. We’ll look at each, starting with risk tolerance.

I mention risk tolerance and time horizon together because the two really go hand-in-hand. In other words, your risk tolerance should be based on your time horizon, which is the amount of time you have until you need the money you are investing.

If you are investing for a retirement that’s more than 20 years away, you have plenty of time to weather the market’s ups and downs, so your tolerance for a market downturn should be a lot higher. After all, growth stocks have outperformed value stocks over the long term, so this volatility we’re seeing now shouldn’t be too concerning in the long run.

However, if your time horizon is shorter, say for college tuition payments in five years, you may have a lower risk tolerance — and for good reason. If you’re going to need the money in a few years, you don’t want to see your portfolio loaded with tech stocks that drop 40%.

Also, you should consider how you felt during this most recent downturn and the bear market we saw in 2020. If you found both of these market events unsettling or had losses that were beyond what you had anticipated, you may have more risk in your portfolio than you are comfortable with. That leads to our second point.

2. Revisit your asset allocation

Your asset allocation is how your portfolio is split into different assets — primarily stocks, fixed income, and cash or money markets. Your asset allocation should be based on your time horizon and risk tolerance.

There is no right asset allocation; it all depends on the individual. Generally speaking, the longer the time horizon you have, the more you want to allocate to stocks, which outperform fixed income investments over the long run. Typically, a ratio somewhere in the range of 80/20 to 60/40 stocks to bonds/cash is what most advisors recommend for someone with a longer time horizon.

But if the thought of another market crash is keeping you up at night, you could revisit your allocation to add slightly more fixed income and cash to provide additional ballast. It may result in lower long-term returns for your portfolio, but you would probably have the comfort of a smoother, less bumpy ride.

3. Diversify, but don’t try to time the market

Diversification is how your portfolio is invested within an asset class. Take stocks, for example. If 90% of your portfolio was invested in stocks and exchange-traded funds (ETFs) focused on the technology sector, you probably took a pretty big hit these past few months.

But tech stocks aside, you don’t want your portfolio too concentrated in any one investment style, sector, market cap, or nation/region because it will likely result in greater volatility. Different types of investments perform differently in various market cycles. Over the past year, value stocks have outperformed growth stocks, and that could continue into 2022 as many growth stocks remain overvalued, and many value stocks perform well in rising-interest-rate environments.

Likewise, sectors like energy and financials have performed well during the time technology stocks have dropped. Further, small-cap stocks perform better in some cycles than large-cap; for example, when coming out of a recession or economic downturn.

To minimize the volatility, it’s best to have a well-diversified portfolio with a mix of stocks that, ideally, offset losses from one type of investment with gains from another during any given market cycle.

But avoid the temptation to trade in and out in an attempt to maximize your returns in any given market; trying to time the market rarely works. All too often, you trade out of a temporarily underperforming stock and lock in those losses. Then, when the market shifts and that stock comes back into favor, you have missed out on all its gains.

So, if you are concerned about the potential for another major market downturn, review your strategy through the lens of these three basic principles, and you should be able to rest easier.

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