One of the hardest events for investors to stomach are market corrections. A correction is a dramatic drop of 10% or more of a stock, bond, or market index such as the S&P 500.
Corrections aren't unusual, although many investors act as if they are, each and every time they occur. In fact, since World War II, there have been 27 market corrections to the S&P 500 Index.1
What's an Investor to Do?
There's a saying that doing nothing is doing something, although that's not advice many investors consider. However, making rash decisions during market turbulence is like jumping off a roller coaster midway through the ride. That's why it's important to establish an investment strategy.
Start by identifying your investment goals, risk tolerance and investing time horizon, then use this information to tailor your portfolio's allocation. It's also wise to review your investing mix and criteria at least annually, because you may need to change your initial portfolio allocation. Before making any changes, keep in mind that your investment criteria may actually be more important than large shifts in the market.
Your investment portfolio may include a mix of stocks, bonds and cash to help manage risk. This is known as asset allocation and can help you weather the market's gyrations and take advantage of its upturns. That's because each asset tends to behave differently depending on how the market is behaving. For instance, in general, when the market is down, bonds perform better and when it's on an upswing stocks do.
While stocks come with more risk, the average returns historically are much stronger. Cash or cash equivalents such as money market accounts, share certificates and treasury bills offer safety, but usually offer the lowest returns over the long run. So spreading your money across these asset classes will help you balance both risks and rewards. One simple way to achieve diversification is by investing in mutual funds, accounts that are managed by experts whose primary jobs are to determine the right mix of stocks and bonds based on their funds' objectives.
Understand Your Investing Personality
While it's all well and good to be told you shouldn't panic when the market has its moments, knowing your risk tolerance when investing is critical. By knowing your own limitations, you can create an appropriate asset allocation and achieve your long-term financial goals.
For instance, are you a worrier? Do market drops send you straight into the fear zone? Or are you a risk taker, seeing market drops as a buying opportunity? Maybe you're somewhere in the middle, willing to stay the course as long as your risks are minimized as much as possible. Your risk tolerance is unique to you and your situation, so it may differ from someone who may share similar goals and investing time horizon.
Regardless of your risk tolerance, if you have a longer investing time horizon you can generally be more aggressive with your investments. That's because you have more time to weather the market's storms and make up for any downturns that might occur. As you grow closer to the time when you'll need to use the money you've invested, you should adjust your investing mix to be more conservative to preserve what you've earned.
The truth is, you can't control the market, but you can control the decisions you make. And having a sound strategy that guides you when things turn rocky will help you keep a clear head and stay the course.
- Source: CNBC