What to Do In a Market Correction

What Should You Do When the Market Goes Down?

nest egg_investing in market correction
What should investors do before, during and after a market correction?. Getty Images

When stock prices are falling fast and furious, what should investors do?

In a market correction (10% decline) or full bear market (20% decline or more), there are some actions investors can take to either protect against further declines or to take advantage of buying opportunities or both.

However, we'll start with the best kind of protection, which takes place before the correction or bear market.

Know Your Risk Tolerance

If you think you'll want to jump off of the biggest roller coaster at the amusement park, you shouldn't get on it in the first place! In the investment world, this is a bit of self-knowledge called risk tolerance, which is is an investing term relating to the amount of market risk, especially the volatility (ups and downs), an investor can tolerate. Usually gauged by a calculator or questionnaire, risk tolerance is often used to categorize investors as Aggressive, Moderate or Conservative.

For example, a risk tolerance questionnaire may ask several questions with various market scenarios and the investor will anticipate their reaction to the given market scenario and answer the questions accordingly.

A sample question is, "What would you do if the stock market fell by 20% over the course of one year? Would you A) Do nothing, B) Wait a few months to make a decision, or C) Sell your stocks immediately.?"

An aggressive investor would likely answer 'A,' a moderate investor 'B' and a conservative investor 'C.' The intention of the questionnaire is to help the investor build a portfolio of investments that the investor will be comfortable with over long periods of time. Abandoning an investment strategy abruptly due to stock market activity is not usually the best reaction.

Therefore a risk tolerance questionnaire should aid the investor by anticipating and preventing poor investing behavior.

Do Nothing and Remain Calm With Knowledge of Market History

If you have prepared your portfolio to meet your goals and suitability, and you are a long-term investor, there's no need to do anything when the market goes down.

However, it is still understandable if a major market correction makes you nervous. It is natural to think you need to do something when the media is constantly warning about negative market outcomes.

To remain calm while doing nothing in the storm, here is some history on market corrections to consider:

  • A 10% correction occurs on average once per year. The average recovery time for a decline of 10% or more is approximately 10 months.
  • The historical average return for stocks since 1950 has been about 10%.
  • If a portfolio is moderately allocated (i.e. 60% stocks, 40% bonds) it will not typically fall down as far as the stock market. For example, when the market falls 10%, a moderate portfolio of mutual funds may fall somewhere between 5% and 7%, depending upon the allocation.

The only investors in the market that have good reason to sell stocks during a correction are those who need cash immediately or within the next several months.

Generally, any cash needed within three years should not be invested in stocks or bonds or mutual funds.

How to Invest for a Bear Market

Investing for a bear market is the equivalent of preparing for a market correction.

As you already know, it is not wise to attempt timing the market by jumping in and out of stock and bond mutual funds but it can be smart to make small and deliberate steps by adjusting the asset allocation of your portfolio.

Asset allocation is the greatest influencing factor in total portfolio performance, especially over long periods of time. Therefore an investor can be just average at investment selection but good at tactical asset allocation and have greater performance, compared to the technical and fundamental investors who may be good at investment selection but have poor timing with asset allocation.

Here's an example of tactical asset allocation: Let's say you see classic signs of a maturing bull market, such as high P/E ratios and rising interest rates, and a new bear market appears to be on the horizon. You can then begin to reduce exposure to riskier stock funds and your overall stock allocation and begin building your bond fund and money market fund positions.

Let's also assume your target (or "normal") allocation is 65% stock funds, 30% bond funds,and 5% cash/money market funds. Once you see P/E ratios at high levels, new records on major market indexes, and rising interest rates, you may take a step back in risk to 50% stocks, 30% bonds and 20% cash.

How to Take Advantage of a Market Correction

If you are a long-term investor, a market correction can be cause for celebration, not concern. The best time to buy is when prices are low and a market correction creates a sale for stocks.

If you are nervous about buying when the market is falling, or if you think you'll make a mistake of some kind by buying mutual funds in a down market, you can take smart preventative measures with a dollar-cost averaging (DCA) strategy, which is simply buying shares of investments at regular intervals. You buy when prices are high, low and in-between. This essentially "averages" the prices down, which gives your funds a boost over time.

You can DCA by setting up a systematic investment plan, also known as a SIP, a recurring investment plan or periodic investment plan. A SIP is an automatic savings strategy that allows an individual to select a fixed dollar amount (or a fixed number of shares if using investment securities, such as stocks, mutual funds or ETFs) and to choose a set frequency of deposit or investment, such as monthly or quarterly. A liquid account, such as a money market account or a bank savings account, is usually used to fund the payments that then go buy shares of the selected investment type.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.