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In this episode of the Science of Economic Freedom podcast, “How to Navigate a Stock Market Correction,” we discuss the proper mindset needed to ensure you succeed during the inevitable periods of market weakness.
The fact is that corrections are both normal, and even essential, to the long-term health of financial markets. Even infrequent bear markets can and will happen, so you need to understand this, and keep these things in the proper perspective.
Topics covered in this episode include:
Make no mistake, corrections, bear markets and even crashes are going to happen. But, your mindset, your asset allocation and the diversity of your portfolio all are key to winning the long game. And in this episode, you’ll learn the right tools—both psychological and financial—to make sure your money prevails regardless of market conditions.
Doug: Welcome to the Science of Economic Freedom. I’m your host, Doug Fabian. This podcast is all about helping you achieve your financial dreams. We call that economic freedom. This program is about your journey to achieve economic freedom for yourself and your loved ones.
Today, we want to help you identify your next step on that journey. This is Episode 28, How to Navigate a Stock Market Correction.
What is your mindset when you hear stock market correction? Is it, “No big deal,” or does the thought of a correction spark the need to do something? Your answer to these questions are important to your long-term investment success. Market corrections are going to happen, period, end of story. Even the less frequent bear market is going to happen again. What gets people into trouble is their reaction to market declines. The purpose of this discussion today is to prepare you mentally for the next market correction so you don’t hurt your long-term success.
Now, let me set some context. First, let’s assume you have a balanced portfolio of stocks and bonds that is tailored to your risk tolerance. This could be 80% equities, 20% fixed income, 70/30 portfolio, or 60/40 portfolio.
Next, let’s assume you are properly diversified. Now, this is a big issue. Diversification is key, it is a close second to asset allocation in terms of importance. It is so easy to diversify today with the access we have to exchange-traded funds and mutual funds, but many investors make the mistake of concentrating in large positions. This is especially problematic during market corrections when a single security can ruin your investment returns. Proper diversification should include international stocks as well as domestic. It is easy to have more than 1,000 positions in your portfolio with just a couple of holdings in ETFs and funds.
Okay, your asset allocation is set for you, and you are properly diversified. Along comes a 10% correction. No big deal, right? An 80/20 portfolio in a 10% correction would mean a drop in market value of approximately 8% hypothetically. A 60/40 portfolio would be a drop of 6%. A 100% equity portfolio would be a 10% drop in a 10% correction. The decline is based on your exposure to equities.
Now, there are two factors that we should point out that are meaningful to this discussion, and both are psychological issues. For many investors, the problem with corrections is not the drop in value, it’s what happens inside their head. A 10% correction could lead to a 15% correction, a 15% correction could be 30%. “I better see what’s going on, scan my favorite websites, tune in to CNBC. Oh, man, the news is not good. Talking heads are predicting that this is just the beginning of something bigger. I better do something.” Predictions and forecasts of what’s to come is what gets investors worked up and causes many to take inappropriate action. A second factor is what’s happening inside your portfolio. Market’s down 10%, you’re down 20%.
Now, you think, “How could that happen?” Easily, if you have exposure to highly concentrated positions. If you have an outsized exposure to a single stock or a sector, this can do it, markets can be down 10, you’re down 20. Now you feel you have to do something because you’re down more than the market, you’re losing money. This goes back to our setup. Do you have an asset allocation that is tailored to your risk tolerance? And, in addition, are you properly diversified? These are issues you can address now and fix prior to the next market correction. A 10% correction would be okay. But what about something worse? What about a 15% decline, or a 20% decline?
Let’s review some stock market history. Here are some facts. These facts are from Robert Shiller, and he examined the period of 1871 to 2016, 144 years. Now, I also added in the two 10% corrections that we had in 2016 and 2018. In summary, we have had 31 corrections between 10% and 14% in the past 147 years. We have had 22 corrections of 15% to 19% in the past 147 years. We’ve had 15 declines of 20% to 24%.
Now, we’re in bear market territory. Any decline greater than 20% is considered a bear market. We’ve had 11 bear markets in the 25% to 29% category, 7 in the 30% to 34%, 4 in the 35% to 39%, 4 in the 40% to 49%, 2 in the 50% to 54%, and 1 greater than 55%, which was the market crash in 1929. Another way to look at this data in more recent times is between 1950 and 2018. We looked at the frequency of occurrence of specific market corrections. Did you know that a 5% correction occurs every year, 94% of the time, a 10% correction occurs every 2 years, 58% of the time, 20% occurs every 5 years, 20% of the time, 30% occurs every 10 years, 10% of the time, and a 40% decline occurs every 50 years, 2% of the time?
Now, the purpose of these statistics is to give you an understanding that whatever happens in the next market correction, in the context of market history, it is normal, we’re going to have these kinds of events, but corrections, crashes, and bear markets happen. We don’t know when, where, or how they will be triggered, but they are a natural phenomenon in the equity markets. So, what should your reaction be to a market correction? Absolutely no reaction. How do you prepare for a market correction? You check your asset allocation, your diversification, and your concentrated position exposure.
Now, here are some guidelines to live by concerning your economic freedom portfolio and market adjustments. And let me remind everyone about the economic freedom portfolio. It is okay to have a speculative account or an account where you’re just going to dabble in some securities, but it is not your serious money. What we talk about here on this podcast, the Science of Economic Freedom, is the serious money. This is the money that is going to enable you to stop working someday, that is going to take care of you and your family, that is going to allow you to live your dreams. So, when we talk about the economic freedom portfolio, we’re talking about the portfolio that really matters.
Now, here are some guidelines to live by.
So, let’s review some action items that you can take to make the most of this visit we’ve had this week.
Number one, review your asset allocation, stress test your portfolio by calculating the effect of a market correction against your equity exposure.
Number two, review your diversification. Are you properly diversified? Do you have international exposure? The US will not always be the world leader in equity performance. Then, in addition, do you have any significant concentrated positions in your portfolio that you should review?
Number three, when a correction does come, come back to the podcast and review the guidelines that we’ve talked about here today. As always, I welcome your comments, questions, and feedback. You can send me an email. It’s [email protected], [email protected]. This is Doug Fabian. Thank you for listening.
Announcer: The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell, or hold any specific security. Consult your investment advisor and read any investment prospectus carefully before making any changes to your investment portfolio.
This program is sponsored by Mercer Advisors. Mercer Global Advisors, Inc. is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors, Inc. is the parent company of Mercer Global Advisors, Inc., and is not involved with investment services.