How To Prepare For A Market Downturn

With the stock market at record highs, a pandemic ravaging our country, and a violent mob attempting to overthrow the government, it’s only a matter of time before the stock market takes a dive. Although it’s unpleasant to see your investments lose value, this is not something to fear. The market goes up and down regularly. After every crash, there is a recovery. If you manage your money wisely, you are unlikely to lose money in the long term. A dip in stock prices can even present an opportunity for future profits. Here are some tips to protect yourself from a market downturn.

1. Don’t panic!

If you’re reading this because the market is already taking a dive, the most important thing I can tell you is not to panic. Even under ordinary circumstances, emotions and investing do not mix well. When the stock market is going up, people tend to buy in for fear of missing out, and when it falls, they tend to sell because they are scared that it will go even lower. And by buying high and selling low, they end up losing their money. It’s important to be a rational investor. If the stock market falls, the best thing you can do is to hold on to your investments. They will more than likely recover with enough time. I know it’s hard to do when it looks like your money is disappearing, but if you can grit your teeth and bear it, you will be better off in the long term.

2. Build up an emergency fund

To prepare for a market downturn, or any potential setback really, it’s important to build up a sizeable emergency fund. You need to make sure that you have enough cash on hand to deal with any financial problems that may come your way. These emergencies may include car or house maintenance, unexpected medical bills, or even losing your job. If you are faced with one of these situations, you want to have enough money available to be able to handle the sudden expenses without going into debt or dipping into your investment or retirement accounts, which could jeopardize your future. Most experts recommend setting aside 3 to 6 months’ worth of living expenses. If you are worried about a market downturn, you might want to save even more. I’d suggest saving enough for a whole year, just to be safe. It also doesn’t hurt to have more on hand so you can invest at a low point when the market does eventually dip, which will allow you to maximize your gains.

3. Diversify your portfolio

Investing is inherently risky, but you can take steps to mitigate your risk as much as possible. One way to do that is through diversifying your portfolio. You don’t want to put all of your eggs into one basket. For instance, you don’t want to invest all your money into one stock. Sure, if that stock does well, you will do well, but if it doesn’t, you could lose all your money. If you have 10 stocks, and 1 goes bankrupt, that’s balanced out by all the other stocks you own. You also want to make sure that you’re not invested too heavily in any one industry. Some sectors are hit worse in a downturn than others, and some may even profit during it. For instance, during the Covid-19 pandemic, retail stores and restaurants were severely impacted, while online shops and services profited. By having broader exposure to multiple industries, you can lessen your risk and take advantage of any standouts. One easy way to diversify is by purchasing low-cost mutual funds. A mutual fund is a professionally managed investment fund that invests your money across a wide portfolio of holdings. One type of fund that’s typically recommended is an index fund, which tracks an index such as the S&P 500. Just make sure to pick funds that do not charge high fees, as these will eat up your profits.

You should also diversify your portfolio across asset classes. Instead of only investing in stocks, you can also invest in bonds, real estate, commodities, gold, etc. Different assets come with different levels of risk, and by holding different assets whose values are not tightly correlated, you can lower your overall risk. For instance, gold prices are not correlated with the stock market, so investing in gold can help to diversify a stock-heavy portfolio. When stocks fall, gold prices may not necessarily be affected. Another option is to consider bonds, which are generally considered less risky than stocks. I’m personally a fan of Worthy Bonds, which provide 5% annual interest on up to $50,000 and allow you to withdraw your money and interest at any time. The objective is to keep a portion of your portfolio in safer investments which can cushion the blow of a stock market drop. However, keep in mind that lower risk generally means lower returns.

4. Reevaluate and rebalance your holdings regularly

Risk tolerance often changes with age. Younger people generally have higher risk tolerance than people closer to retirement since they have more time to ride out market fluctuations. Risk tolerance can also vary more situationally. For instance, if you are planning to buy a house soon, you may need to save up money for a down payment, especially as a first-time homebuyer. In that case, you would be more risk averse because you wouldn’t want to lose that down payment money.

Stocks also change over time. Obviously we hope they gain in value, but that is not always the case. Though you bought a stock for a particular reason, it may no longer seem like such an attractive investment. On the other hand, if one stock vastly outperforms the rest of your holdings, it can cause your portfolio to become unbalanced. You may have begun with equal investment in 10 stocks, but after a couple years, 1 of those stocks may be worth half of your portfolio. Although it is wonderful that this stock did so well, this unequal distribution of your money can put your portfolio at risk. If that stock takes a sudden tumble, your money will be disproportionately affected.

For those reasons, it is important to reevaluate your holdings regularly to assess whether they are still appropriate given your current circumstances. I recommend taking a look at your investments at least once a year to determine if you still want to hold them or if you want to make changes. The reason I prefer to wait a year is due to tax rates on capital gains. If you hold stocks for more than a year (considered long-term), then your profit from selling them will be taxed at a lower rate than your typical tax bracket (if you sell sooner than a year, the tax rate is the same as your typical tax bracket). For instance, if you’re married and filing jointly like I am, you pay 0% tax on up to $80,000 in long-term profits. By comparison, the lowest tax bracket in 2020 for ordinary income is 10%, and that’s only for income up to $19,750 if you’re married and filing jointly. Using the same filing conditions (and no additional income), if you make $80,000 in profits from short-term stock sales, you will have to pay $9,205 in taxes, meaning that you will only net $70,795. That’s a huge difference and makes clear why taking advantage of long-term capital gains tax rates is worthwhile.

5. Use automated/recurring investment options

If you are able to time the market, you can make quite a bit of money, but this is not easy to do and can be quite stressful. You can also end up holding a lot of money in cash waiting for a downturn, which means that this money is not working for you. One way to avoid this stress is to make use of automated or recurring investment options. If you invest $100 every month, then you don’t have to worry about whether the market is up or down when you invest. Your money will continue to grow regardless. Automated investing is also good for people who have trouble budgeting. If you set up your accounts so that a certain amount is taken out monthly for investing, then you do not have to worry about spending it and having nothing left over to save.

Summary

If you’re worried about a market downturn, you should take steps to prepare in advance. First of all, don’t panic! Emotional investing can take a toll on your finances. It’s better to hold on to your current investments and wait out a crisis than to do something rash that could make things worse. Second, make sure you build up a comfortable emergency fund in case you need to have money on hand. It’s much easier to wait out a downturn if you have available cash. Third, diversify your investments to decrease your risk exposure. Not every industry or asset class will be affected by a downturn in the same way. Fourth, reevaluate your investments on at least a yearly basis. Make adjustments and rebalance as needed. Fifth, consider using automated, recurring investment options. This should help to decrease stress about trying to time the market.

Overall, remember that investing always comes with risk. These tips are not foolproof, but they should offer some general assistance. For specific investing advice, consult with a professional financial advisor about your own particular circumstances.