With market indexes consistently flirting with all-time highs in recent months, many investors are starting to wonder if and when a downturn in the markets will hit and what to do when prices begin to fall.
The United States economy has been growing at a slow but steady pace over the past several years, but an eventual downturn is a part of the economic cycle. Other factors like the current volatile political climate, global events and the overall economic outlook can also have an impact on the markets.
It is important to understand a downturn, whether a short-term correction or a long-term bear market, will occur at some point, and although it is generally difficult, if not impossible, to foresee and time a downturn, there are some steps investors can take to prepare and protect themselves.
Asset Allocation
A key factor in determining success in investing is asset allocation, an investment strategy used to distribute investments among different asset classes such as stocks, bonds and cash and cash equivalents.
The best allocation strategy depends on the individual investor’s goals, timeframe, risk tolerance and other factors. Is the investor looking for a long-term or short-term strategy? What is the investor’s age? How does the investor feel about taking on additional risk for a potentially higher return?
Generally speaking, a younger investor can choose to allocate their resources to comparably riskier investments like stocks, because the investor has more time to recoup short-term losses. An older investor, who is closer to retirement, might want to invest in comparably less risky investments like bonds and cash equivalents.
Diversification
Diversification helps investors manage unsystematic risk by using a wide variety of investments in the investor’s portfolio.
On average, a portfolio consisting of different types of investments could yield higher returns while potentially exposing the investor to a lower level of risk.
This risk management technique uses securities that are not perfectly correlated to offset the potential negative performance of some securities with the potential positive performance of others.
In practice, an investor might want to choose 20 to 30 securities for his or her portfolio that are in unrelated sectors.
If one sector hits a downturn, and the price of securities in that sector drops, the investments in the other sectors could be shielded from the drop in price, because the investments are not perfectly correlated.
Dollar-Cost Averaging
Since it is impossible to time the market, dollar-cost averaging is an investment technique that could lower the average cost of investing in a security over time.
This technique involves investing the same dollar amount in a security on a regular basis for a certain period of time.
For example, if an investor has $500 to invest in a stock, mutual fund or another security, the investor could invest in increments of $100 per month over a five-month period.
As the price of the security fluctuates to say $25, $27, $24, $28 and $26 over the five-month period, the investor continues to purchase $100 worth of the security every month.
At the end of the five months, the investor has invested the $500 and accumulated 19.29 shares of the security with an average cost per share of $25.92.
This is lower than what the average cost would have been if the investor bought the security in months two ($27), four ($28) and five ($26).
The investor would have paid a lower cost per share if he or she bought the security in months one ($25) and three ($24), but since the investor can’t time the market, discounted-cost averaging can be a useful strategy in potentially lowering the average price per share.
Don’t Panic
Investors don’t like to see the prices in their securities or funds drop. If an investment isn’t doing well, an investor’s initial response may be to get out and move into something with more favorable returns at the moment.
A potential pitfall to this behavior is the investor may be prematurely cashing out of an investment that has long-term potential and buying an investment that has already made its substantial gains in the short-term.
The old adage “Buy low, sell high” may be difficult to execute in practice, but it is a good reminder of the potential pitfalls when investors chase returns.
Diversification may help reduce, but cannot eliminate, risk of investment losses. Historical performance relative to risk and return points to, but does not guarantee, the same relationship for future performance. There is no assurance that by assuming more risk, you are guaranteed to achieve better results.
Using dollar cost averaging does not assure a profit and does not protect against loss in a declining market. Also, using this investment method involves continuous investment in securities regardless of fluctuating price levels of securities. Therefore, an investor should consider his/her financial ability to continue purchasing through periods of low price levels.
