How to Prepare for a Stock Market Correction
It's coming sometime, so here are ways to protect your investments and sleep better
One of my favorite folk tales centers around a landowner hiring a farm hand. In their first meeting, the applicant explained his qualifications by saying "I can sleep through a storm." A week later, a violent storm tore through the area and the farmer tried vainly to wake up the farm hand. The next day, the farmer found that the shutters had been fastened, tools had been securely stored, the wheat had been bound and wrapped, the barn had been locked and the animals were calm with plenty of food. Suddenly, the farmer understood the young man's words: "I can sleep through a storm."
He had prepared ahead of time and could sleep peacefully during the tempest. Sleeping well is the second goal of investing and becomes easier with the right preparations. (The first goal is not to lose money and the third goal is to make money.)
"The proverbial Wile E. Coyote moment lays ahead."
By taking the right precautions now, you can sleep soundly when the stock market drops precipitously and stays there for awhile, something that's bound to happen sometime.
"The proverbial Wile E. Coyote moment lays ahead," says James Athey, investment director at Aberdeen Standard Investments in London, referring to the speedy roadrunner who looks down to see that he has run off a cliff, realizes he no longer has ground beneath him and plummets.
What's Behind Fears of a Stock Market Correction
Stock market volatility, caused by a range of factors including worries about inflation, interest rates and supply chain problems, amplify fears of a coming market correction (that's a drop in stock prices of more than 10% but less than 20%) or even a crash (a sudden and precipitous drop).
The markets (and by extension investors) suffered a gut-wrenching day on Wednesday, Dec. 1, when the Dow Jones Industrial Average dropped by 652 points or 1.9%. The S&P 500 closed down 1.2%, its worst one-day drop since mid-May. Stocks fell again sharply in mid-December. But the S&P 500's total return for 2021 was impressive — roughly 25%.
Preparing for a correction starts with understanding the inevitability of small-sized corrections and lesser likelihood of a major correction, says Alex Klingelhoeffer, a financial adviser at Oklahoma City-based Exencial Wealth Advisors.
"A correction is always around the corner," he notes. "Typically, we have a garden-variety correction once every eighteen months." Deeper corrections happen less frequently.
"What keeps folks up at night is the big one. Major corrections of more than twenty percent have happened seven times in the last hundred years," Klingelhoeffer says. They were in 1929, 1937, 1939, 1946, 1973, 2000 and 2007.
The Best Defense for Investors
Diversification is the best defense. That means having enough cash and bonds in your portfolio to cover all foreseeable expenses for five years. That means trading off the low income generated by those assets against having to sell off stocks eroded by a correction.
The current 1.21% interest rate on, say, five-year Treasury bills "is a terrible rate," Klingelhoeffer says, but "if the market corrects and you have a thirty percent drop, your bills are not going to drop."
Precious metals such as gold and investments in real estate can also provide some reassurance.
Stable sources of income such as salary, pensions and Social Security can reduce the total amount you might want in cash and near-cash holdings as protection against a stock market collapse.
It also helps to own stocks of international markets which might not fall as much as the U.S. market during a correction.
Emerging markets in Brazil, Russia, China and India, which have lagged the United States for more than a decade, don't all run in the same direction at the same time.
Real growth in the world economy is coming from these areas and they can provide opportunities and ballast for a U.S.-centered portfolio, especially when U.S. markets underperform.
Precious metals such as gold and investments in real estate can also provide some reassurance. "They're not making any more land," Klingelhoeffer adds.
He also favors investing some money in a basket of commodities, including wheat, corn and lumber.
"These are things that we use and need to live," he says, adding that they have a low correlation to the overall stock market. You can invest in commodities through commodity exchange-traded funds or ETFs.
Investors may have some time to implement these strategies (though not an unlimited amount of time), since a major correction could occur over six to 12 months, according to Athey.