The stock market can be a dangerous place – for some investors.
What should you do when there is a stock market correction?
What should you not do when there is a stock market correction?
Read on for our take and words of wisdom in 3 Ways to Prepare for the Coming Stock Market Correction.
Stock market history can be the best teacher
“The wonderful magic of compounding returns that is reflected in the long-term productivity of American business, then, is translated into equally wonderful returns in the stock market. But those returns are overwhelmed by the powerful tyranny of compounding the costs of investing. For those who choose to play the game, the odds in favour of the successful achievement of superior returns are terrible. Simply playing the game consigns the average investor to a woeful shortfall to the returns generated by the stock market over the long term.” – John Bogle, founder of Vanguard Group.
We feel this quote represents succinctly how most Canadians should consider investing – as a multi-year long-term endeavour.
We captured this quote in our Four Keys to Investing Success.
In a nutshell:
- Understanding and learning about investing theory,
- Keeping market history top of mind,
- Understanding some of the psychology related to investing, and
- Remaining wary of the financial industry – are all great keys to investing success.
When it comes to stock market history, in particular, a BIG reminder that fortunes that have taken years or decades to build can be lost quickly when it comes to investing. Your returns can be significantly compromised by the immense drawbacks associated with trying to time the market or simply jumping out of it when things go sour. This is because knee-jerk reactions to stock market changes are rarely a recipe for success.
Have a look at this recent chart following the TSX:
Lots of volatility right?
Well, market volatility is actually, entirely, fully and completely – normal.
As an investor, you need to accept market volatility because as an investor you are getting paid to own stocks. It’s the premium you pay to enjoy the ride!
1. Do – Keep Cash on Hand
While no investor can accurately predict the next stock market correction, the best investors are always ready to buy more assets if and when stocks go on sale.
Investors holding large amounts of dividend stocks, for example, may turn off reinvestment plans and hold onto cash as a hedge – ready to deploy accumulated cash on hand at better prices.
Check out How to Automatically Reinvest Dividends and why this approach, generally speaking, can work for you.
2. Do – Hold a more balanced portfolio with fixed-income assets
While it can be painful to watch your investment accounts shrink in value if it’s really too much to take, reconsider your asset allocation and add more fixed-income assets.
Investors who are unable to ride out stock market volatility may consider moving some of their money into fixed-income investments like bond funds or bond Exchange Traded Funds (ETFs). The good news for some market-fearing investors is fixed-income investments tend to move inversely to the stock market. This means, when stock prices fall, bond prices go up. In the event of a major market selloff, bond prices could fall in value as well but they will at least be a parachute of sorts for your portfolio overall.
As with any form of investing, there are always tradeoffs. Any big bet on fixed income right now is likely to be a long-term loser to inflation. But, you don’t own bonds to make lots of money. Instead, consider owning some bonds as a way to protect yourself from yourself during the next stock market correction.
3. Do – Buy When You Can!
Speaking from our own lessons learned, we can attest that while our stomachs might churn with the stock market is down 10%, 20% or more, the decision to buy stocks at lower prices has generally turned out great.
One way to buy stocks during a down market is through a strategy known as dollar-cost averaging. Another method is lump-sum investing. Both approaches have pros and cons but we believe where possible, it makes sense to buy when you have the money to do so in a lump sum.
First, we have no idea if the stock market is going to go up or down tomorrow, next week, next month or otherwise. But, we do know lump-sum investing gets money working as soon as possible.
Second, given markets tend to go up over time (see our charts above!), you have a better chance of ending up with more money by investing in equities at once versus in phases over time. Of course, there are absolutely times when stocks go down, significantly, and stay down. Market volatility remember is very real and normal. The challenge, we don’t know when that will happen. But overall, you’re more likely via the chance to be giving up investment gains through dollar-cost averaging instead of lump-sum investing.
Three, and maybe our most important point for you, think of DCA as market timing. You are strategically setting up intervals or timing your purchases that may or may not work out when it comes to market pricing.
That said, the DCA approach can make you emotionally feel better since you’re not investing lump sums of money at once. It may seem less risky, therefore feelings that are reducing your stress by potentially reducing the impact of market volatility. This is not wrong whatsoever, it’s just your plan.
At the end of the day, saving and investing including your assets in the stock market will be just as much emotional decisions as math decisions. While buy-buy-buy in a down market often pays off big, there’s a chance that the market hasn’t hit its bottom yet. However, even if you never “catch the bottom” it doesn’t really matter much. By staying investing and simply trying to add to your portfolio in a down market, you’ll simply enjoy larger gains anyhow.
How well have investors done by simply staying the course?
- Portfolio: 80% equities/ 20% fixed income
- Annual Return: 5.70%
- Retirement age: 40
- TFSA Balance: $100,000
- Inflation rate: 2%
Stress Test #1: Holding your investments through the worst historical repeating 20-year sequence of returns:
Using our retirement projection tools (contact us if you need some help with your portfolio management and financial projections), we performed a “stress test” on the portfolio using the worst 20-year sequence of returns which then repeats until age 100. This period covers the dot com bust, financial crisis, and the COVID correction and repeats this 20-year period few times until age 100.
In this scenario, when holding through all the market crashes, the investor still ends up with a TFSA worth $2.3M (in future dollars) or $700k in today’s dollars (ie. after-inflation).
Stress Test #2: Holding your investments through the worst historical repeating 15-year sequence of returns:
Let’s stress test even further by holding through the worst 15-year sequence of returns (and repeat). The result? You guessed it, the portfolio survived and is worth much more than the original $100k. How much more? At age 100, the TFSA grows to $1.3M.
Do’s and don’ts during the next stock market correction summary
Every investor has their own way of dealing with poor market conditions. We believe the following “do’s” will help you:
- Do keep some cash on hand.
- Do consider more fixed-income if the stress test becomes too much.
- Do consider buying more equities when stocks are on sale.
In our opinion:
- Don’t give in to market rhetoric and noise – remember our Four Keys to Investing Success.
- Don’t liquidate your equity assets.
- Don’t try and time the bottom – accept that investing comes with market volatility.