The media can get a little excitable at times when market indexes go on a weekly losing streak or have a down month like it did in September. Questions inevitably come up asking if or when a market crash will happen. We won’t take the bait, and we won’t say, especially since prognosticators have been calling for one since 2012. Had you listened to them, you would have been left out on the sidelines as the market made some record-setting advances in 2013. But it does raise a good question, in case one does happen:
How can the common investor prepare themselves for the next market crash?
The first best thing they can do is to make sure their asset allocation, their portfolio’s mix between stocks and bonds, is truly in line with their risk tolerance. The enormous gains over the past five years for the stock market have resulted in stock-heavy portfolios, and that means investors have more exposure to a risky asset that historically can go up or down 20% in any given year.
Consider taking a questionnaire to determine your target asset allocation. Vanguard offers a good one:
If your asset allocation is out of line with your risk tolerance, there’s a greater chance that you’ll panic and abandon your investment plan at the point of maximum fear, and that’s a common pitfall that has caused investors to underperform the stock market.
Mark Hulbert mentioned in a June article this year that a 60% stock / 40% bond mix historically participated in about 85% of the upside of an all-stock portfolio while nearly cutting your portfolio’s risk in half (as measured by volatility of returns). This protection, however, comes at a cost, with returns averaging 1.4% a year less per year (8.7% annual returns for a 60/40 mix vs. a 10% return for an all-stock portfolio). But the risk-reward trade-off benefits are enormous, since in brutal bear markets, the bond allocation can soften the blow to your portfolio. The less you lose, the less you have to make up: remember, a 50% loss requires a 100% gain just to get back to square one, and a 25% loss only requires a 33% gain to get even.
The key is to have a plan that you won’t abandon at the peak of market panic. Have an asset allocation that lines up with your risk tolerance, rebalance when it gets out of line, and you’ll be able to calmly navigate the waters when everyone else is splashing about.
(Posted October 2, 2014)
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Rainier Trinidad, CFA
San Diego and Coronado’s Fiduciary Financial Advisor
Parabolic Asset Management
206 J Avenue
Coronado, CA 92118
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