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How to Navigate a Stock Market Correction

September 14, 2018

By Doug Fabian, Mercer Advisors

When you think about a stock market correction slamming into your portfolio, what’s the first thing that comes to mind?

Are you the type that remains calm, realizing that market corrections happen regularly, and that they are part of the game when investing in equities? Or, are you the type that becomes overwhelmed with fear when you think of protracted periods of declining equity values?

The fact is that corrections and bear markets are going to happen. And while it may not seem like it given we haven’t seen a sustained period of declining stock prices in some time, the next pullback is just waiting in the wings… ready to strike the unsuspecting investor.

To get a sense of just how frequent corrections and bear markets occur, I turned to research from renowned economist and Yale professor Robert Shiller (he of the Case-Shiller Home Price Index fame).

Shiller looked at the markets from 1871-2015. Since 2015, there have been two 10% corrections in the market (one in 2016, and one earlier this year), so we must add those to the Shiller research. So, over the entire period, there have been 31 corrections of between 10% and 14%. Additionally, there have been 22 corrections of between 15% and 19%.

As for corrections that have morphed into actual bear markets, there were 15 times where the market saw declines of between 20% and 24%. And then, there were 11 times the market fell between 25% and 29%. Yet things can and do get worse, with seven periods where the market fell between 30% and 34%.

There were four times when the market fell between 35% and 39%, and four times when those declines reached between 40% and 49%. And then, there were two times when the market went into a full-blown crash of between 50% and 54%, and once when the market plunged nearly 90% (the crash of 1929).

Perhaps a better way to look at this data is to concentrate on the more-recent periods (in this case I’ve chosen between 1950-2018, a period when most of us have lived and invested) to help us understand the relative frequency of corrections and bear markets. Doing the math, we see that markets fall 5% in any given year some 94% of the time. That means a 5% pullback happens nearly every year. Moreover, a 10% pullback from the highs (the official threshold for corrections) occurs every two years, or 58% of the time.

An official bear market, i.e. a 20% pullback from the market’s highs, occurs every five years, or 20% of the time. And to round out the data, a decline of 30% happens every 10 years, or 10% of the time, while a 40% decline occurs every 50 years, or 2% of the time.

The point of all this data is to make you understand that corrections, bear markets and even full-blown crashes will occur. It’s not a matter of if they’ll occur. We don’t know when they will occur, and neither does anyone else, and please don’t believe any pundit that tells you his/her secret formula can forecast the future. It can’t.

So, that leaves us with a serious problem.

If corrections and bear markets are going to happen, how do we handle these events as investors?

The first key to navigating a stock market correction is to have the proper mindset. For many investors, a penchant for overreacting to even a mild drop in equity prices can prompt a premature selling of otherwise sound equity positions. This proclivity toward reacting, and ultimately overreacting, to every decline in stocks is something that a well-diversified, long-term investor should avoid.

To help you avoid overreacting, I recommend avoiding the temptation to constantly stare at the value of your equity holdings, and to avoid reading hyperbolic websites and watching fear-mongering commentary of the sort you see on financial and network television. The media’s job is not to give out sound financial advice. The media’s job is to get ratings, and there’s nothing like a little amped-up fear to move the ratings’ needle higher.

The second key to navigating a market correction is to make sure you have the proper asset allocation in place for your risk tolerance, and that you have a diversified portfolio of equities that avoids highly concentrated positions of more than 5% in any one equity holding.

By having an asset allocation that’s in line with your risk tolerance, and by properly diversifying your equity holdings, you will largely mitigate the damage incurred by corrections and even bear markets. Plus, your holdings are far more likely to make a robust comeback when the inevitable bull market returns to Wall Street.

At Mercer Advisors, we specialize in helping investors cultivate the proper mindset. We do that by helping our clients define their risk tolerance, and by helping them put together the proper asset allocation model and diversified equity portfolio that’s commensurate with their individual situations and goals.

If you’re worried about potentially overreacting to the next correction or bear market, we can help you sleep better at night. For a free, no-obligation wealth coaching session, simply visit our wealth coaching consultation website, or email us at [email protected]

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