Planning for a Market Downturn

January 25, 2022

Because stock market crashes can be terrifying to contemplate, investors often avoid thinking about them at all—especially during long-running bull markets like the one we’ve seen these past 12 years.

Market downturns, or corrections, tend to happen when people least expect. Like a bad blizzard or dangerous hurricane, investors know another is likely to occur—but when and how big are anyone’s guess. Even though no one can predict when the next storm will hit, there are things investors can do to feel better prepared for the next severe market decline.

And contrary to human behavior, the best time to act is before the next market downturn occurs. Waiting until the winds start to gust, or the rain starts to fall, can be costly. So, what can investors do now to prepare for market volatility in the future?

STAY INVESTED

First, it’s important to acknowledge that basic human instincts are at odds with what it takes to invest successfully over the long term. After all, what did our ancestors do when faced with danger? It was either fight or flight. “Do nothing” probably wouldn’t have been a good strategy, but it’s exactly what most investors should do when a sharp downturn occurs.

BE PATIENT

Patience is key. As Oracle of Omaha Warren Buffett says, “The stock market is a device for transferring money from the impatient to the patient.” When markets are volatile, either up or down, it’s easy for investors to let emotions like euphoria or fear get the better of them, causing them to make impulsive investment decisions. Being aware of how emotions can impact decision-making is a great first step to avoiding making bad investment choices when a market decline does happen.

RESIST THE URGE TO SELL AT THE WRONG TIME

A well-known cognitive bias humans have is loss aversion. Put simply, people have a stronger negative reaction to losing money than they do a positive reaction to gaining the same amount. How does loss aversion play out for investors? It can cause investors to sell at their most panicked, when stock prices have already considerably declined.

When panic sets in and investors are tempted to sell, stop and ask:

• Who is buying my shares?

• Why would they buy my shares?

• Could it actually be a good time to buy?

Asking these questions reminds one that there are two sides to every trade. And the person on the other side may be just as knowledgeable, or more so, on current and future economic conditions. Thinking about the answers to these questions can temper the urge to sell.

Bear markets don’t pose the same “danger” that sabertoothed tigers did our ancestors. Pausing and thinking critically can help overcome the fight or flight instinct.

USE HISTORY AS YOUR GUIDE

Knowledge of how markets have behaved in the past can be a highly effective tool for calming investor emotions or overcoming cognitive bias. What many investors don’t realize is just how quickly markets tend to bounce back after hitting bottom. In Figure 1, an analysis of bounce backs since 1926 shows that markets tend to rebound swiftly and strongly.

Figure 1: Markets Can Bounce Back Swiftly and Strongly

FAMA/FRENCH TOTAL US MARKET RESEARCH INDEX 1926—present: Fama/French Total US Market Research Factor and One-Month US Treasury Bills.
Source: Ken French website. Investing risks include loss of principal and fluctuating value. There is no guarantee an investment strategy will be successful. Past performance is no guarantee of future results. Short-term performance results should be considered in connection with longer-term performance results. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.
Market declines or downturns are defined as periods in which the cumulative return from a peak is –10%, –20%, or –30% or lower. Returns are calculated for the 1-, 3-, and 5-year look-ahead periods beginning the day after the respective downturn thresholds of –10%, –20%, or –30% are exceeded. The bar chart shows the average returns for the 1-, 3-, and 5-year periods following the 10%, 20%, and 30% thresholds. For the 10% threshold, there are 28 observations for 1-year lookahead, 27 observations for 3-year look-ahead, and 27 observations for 5-year look-ahead. For the 20% threshold, there are 14 observations for 1-year look-ahead, 13 observations for 3-year look-ahead, and 13 observations for 5-year look-ahead. For the 30% threshold, there are 6 observations for 1-year look-ahead, 3-year look-ahead, and 5-year look-ahead. Peak is a new all-time high prior to a downturn. Data provided by Fama/French.

Selling during times of fear can cause investors to miss out on the sizable recoveries that have historically followed downturns. Those who choose to stay invested tend to achieve higher returns over the long-term than those who cash out altogether or who exit the market near its lowest point, only to reinvest a year later (Figure 2).

Figure 2: The Importance of Staying Invested

The image illustrates the value of a $100 investment in the stock market during the period 2006-2020. Data sources: Strategic Capital Investment Advisors. The market is represented by the Russell 3000 Index. Cash is represented by the 30-day U.S. Treasury bill. An investment cannot be made directly in an index. The data assumes reinvestment of income and does not account for taxes or transaction costs. This is for illustrative purposes only and not indicative of any investment. This information has been taken from sources, which we believe to be reliable, but there is no guarantee as to its accuracy. For index definitions please visit http://mfinwealth.com/index

Short-term volatility can be the wind that whips up investors’ emotions, but as Figure 3 shows, market highs and lows throughout the year are nearly always muted by the time the year ends. In other words, investors may want to resist the urge to sell (or buy) when emotions are running high. Instead, consider staying invested and focused on your long-term plan.

Figure 3: Short-term Fluctuations Rarely Result in Annual Changes

Data source: Dimensional Fund Advisors. In US dollars. Data is calculated off rounded daily returns. US Market is the Russell 3000 Index. Largest Intra Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra Year Decline refers to the largest market decrease from peak to trough during the year. Past performance is not a guarantee of future results. An investment cannot be made directly in an index. This information has been taken from sources, which we believe to be reliable, but there; is no guarantee as to its accuracy. For index definitions please visit https://mfinwealth.com/index

FEEL BETTER PREPARED

Preparing for an eventual market downturn is no different than prepping for any challenging event. A winning strategy includes practicing how you’ll react when the event occurs and having a plan to fall back on for when you’re less able to make rational decisions. Understanding how emotions can impact decision- making and knowing how markets have behaved during previous downturns and afterwards may help investors feel better prepared for the inevitable, yet unpredictable, market storm—and less anxious when the clouds do descend.

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