Many investors are growing anxious about ominous signs looming on the stock market horizon. The major indexes are near their all-time highs, and valuation ratios are well above their historical averages. Meanwhile, unemployment figures and other economic indicators aren't suggesting that a rapid economic recovery is taking hold. If you're confident that another stock market crash is around the corner, then you should adjust your portfolio accordingly.
Before taking any drastic steps, though, keep this in mind: You might be absolutely certain that doom is imminent, but the bear market you foresee may not arrive on schedule.
The country might instead, for example, experience a period featuring more inflation, during which the S&P 500 remains high due to economic recovery and accommodative Federal Reserve policy. If that scenario or one like it comes to pass, the stock market will be a much better place to have your money than in the bank. A drastic move, like selling all of your stocks and exiting the market altogether, could completely undermine your long-term returns.
Instead, your goal should be to minimize potential losses relative to the market if it heads down and to position yourself to outpace the market when it's on the way up. These strategies could help.
1. Make sure you have the right allocation to cope with volatility
If you're worried about a market correction, now is the time to review your bond allocation. Bonds can help reduce the volatility risk in your portfolio while still delivering returns, which is why people with a low tolerance for risk usually put a larger share of their investments into them.
Also, given that the next market crash could be accompanied by a recession, this would be a good time to make sure that you have enough cash on hand to cover expenses for a few months. A well-stocked emergency fund significantly boosts the chances that you'll be able to handle an unexpected loss of income without being forced to sell stocks while they're temporarily down.
Again, this is not to suggest that anyone should sell all of their stocks and move entirely into bonds and cash. Retain balance in your portfolio -- there are ways to determine the appropriate proportions of bonds versus equities for you. To quantify your appetite for volatility and loss, you may want to take a risk tolerance questionnaire or consult a financial professional. These options can help you come up with an asset allocation strategy that you'll be comfortable with.
2. Diversify and invest for dividends
It's smart to diversify your holdings to reduce risk in general, but investors will feel especially good about having embraced this principle when bear markets arrive. Aggressive growth investors might have some distaste for the way diversification can limit their gains, but that's less of an issue when the market is tumbling. Owning shares of companies in a variety of industries and sectors means you have a better chance of avoiding over-exposure to the stocks that are falling the hardest. And having positions in defensive businesses could allow you to minimize your drawdowns during a crash.
It's also a great idea to dedicate a meaningful portion of your portfolio to reliable dividend stocks. Companies that prioritize their payouts are often mature, stable businesses with predictable cash flows, such as utilities or consumer staples providers. These sorts of businesses frequently perform better than average in recessions. Even more importantly, when stock prices are deteriorating, those dividends can shore up the value of your portfolio -- or provide you with extra income that you can access without selling shares.
3. Have some liquidity available to deploy for the rebound
You might expect the market to crash soon, but if that steep decline comes, it will almost certainly be followed in due course by a rally. And ahead of that rally, investors will have many opportunities to buy stocks when they're on sale.
However, you can't snap up cheap stocks after they've been mauled by a bear market unless you have the cash to do so. Therefore, it's good to have some funds held in assets that are relatively liquid and uncorrelated with the stock market. Those include cash, CDs, money market funds, some gold-related investment vehicles, some bonds, and certain cash-value life insurance products.
Again, that's not to suggest that anyone should sell all their stocks and start buying those alternative investments. But it would be a good idea to start developing positions in some of those conservative asset classes so that you'll be prepared for any and all financial conditions. If you've already built a stockpile of these assets, sit tight and be ready to deploy your "dry powder" when stocks get cheap.
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