Yahoo Finance How to Brace for a Market Pullback
Most investors know the feeling. It's the feeling that the market has gone too far, too quickly, and a sell-off -- potentially a sharp one -- is right around the corner. The next question is clear, though the answers aren't always apparent: How do you prepare your portfolio for a market pullback?
As you might expect, there are a lot of options on the table. But before exploring those too deeply, you need to first take a step back and ask yourself a very important question.
Do your portfolio allocations align with your risk tolerance? Put simply: if you can't handle -- emotionally or financially -- what your portfolio would look like after a 20 percent sell-off in the stock market, you should reduce your exposure to stocks.
[See: The 25 Best Blue-Chip Stocks to Buy for 2017.]
Twenty percent sell-offs may be somewhat rare, but they happen. And smaller pullbacks, also known as drawdowns, happen all the time.
"As an equity investor, every year on average you have three pullbacks of at least 5 percent. An investor by themselves should not try to play every one of those pullbacks. But they should expect it," says Keith Lerner, senior vice president and chief market strategist for SunTrust Investment Advisory Group.
Larger pullbacks happen pretty regularly too.
"Every year on average we have at least one 10 percent pullback. If you go back to 1980 the average drawdown is 14 percent," Lerner says.
Bottom line: volatility is a fact of life in the stock market. If you're not OK with the level of equity risk in your current portfolio, just reduce it.
Don't try to time the market. Yes, it's tempting to act on the feeling that the stock market is overheated and you feel like a sell-off could come at any minute. But there's an old Wall Street phrase that all investors should heed carefully: "Time in the market is more important than timing the market."
The truth is, consistent and accurate market timing is impossible. Most people sell too early and buy back in too late. As Peter Lynch, one of the best investors of all time, once said: "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves."
If you don't want to outright bet on a correction being around the corner, but do want to make sure you're prepared, there are a few boxes you should check right off the bat.
General strategies to reduce the hit to your portfolio. First off, make sure you're adequately diversified. You sacrifice some upside but also limit your downside risk.
Also, make sure to rebalance your portfolio.
"Many people find that after a long run in the stock market their allocation to equities is a much higher percent of total assets than they realized. Simply paring back the stock position and reallocating the funds is a simple step," says Don Shelly, a professor of practice in finance at the Cox School of Business at Southern Methodist University.
In a way, both of these go hand-in-hand with aligning your portfolio with your risk tolerance, but it's truly a concept that can't be repeated enough. The general rule of thumb is to rebalance once a year.
Target-date retirement funds can also be nice tools for investors looking for investments that become less aggressive over time on their own. In fact, they automatically rebalance over time to become more conservative, making the impact of any stock market pullback on your portfolio more muted as you approach retirement.
Diversification, rebalancing and target-date funds are three broader strategies that can reduce the impact of a market correction.
If, however, you want to really prepare for a correction or a bear market coming around the corner -- despite the challenges of market timing -- there are ways to do it.
[See: 9 Psychological Biases That Hurt Investors.]
Specific strategies that brace you for a pullback. One of the most traditional ways to prepare for a Wall Street slump is to put more money in bonds. Not all bonds are created equal though, so choosing high-quality bonds is important.
"We looked back since the 1930s at every period where the stock market had a big pullback," Lerner says. "In every calendar year where stocks were down, U.S. government intermediate bonds outperformed stocks."
"In 22 of the 24 years that saw stocks decline, intermediate government bonds rose," Lerner says.
While that's no guarantee of what intermediate government bonds will do in the future, it's a darn good record.
But say you want to be a little more aggressive. "Another option is to buy an ETF, which shorts a major stock index. The advantage of a short ETF versus a put option is that the ETF doesn't expire like the option," Shelly says.
"Many new mutual funds mimic hedge fund strategies. These funds have lower risk and less upside potential and can help lower the overall risk of a portfolio," Shelly says, cautioning that they may not be offered through all retirement plans.
Finally, a classic way to prepare for down markets and outright recessions alike is to load up on gold.
Unfortunately every pullback is different. For example, while gold can act as a hedge in times of volatility, it's generally a bad investment in rising interest rate environments.
"From 1978 through 2013, gold returned 7.85 percent when rates were falling, 8.61 percent when rates were flat and only 4.86 percent when rates were rising," says Bob Johnson, president and CEO of the American College of Financial Services in Bryn Mawr, Pennsylvania.
Keep it simple. Wall Street is volatile and pullbacks -- even steep ones -- are inevitable. Always make sure your portfolio is created with that truth in mind. Being heavily invested in the stock market isn't for everyone.
There's nothing wrong with reducing risk in your portfolio, and aside from diversification and rebalancing, target-date funds and high-quality government bonds can be ways to achieve that goal.
And aside from converting your stocks to cash, there are also plenty of ways to aggressively prepare for a stock market pullback. Put options, short ETFs, mutual funds that mimic hedge funds, and precious metals such as gold can all cover your downside.
But overall, if you're in the markets, try to resist the urge to time them or wager on their decline. The best investor in the world, Berkshire Hathaway (ticker: BRK.A, BRK.B) CEO Warren Buffett, has racked up billions by remaining invested in them through thick and thin. Instead of preparing for pullbacks, he does something else.
[See: 7 Stocks That Soar in a Recession.]
He takes advantage of them.
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