Should You Prepare for a Correction? Yes and No.
Earlier this week, I was talking to an uncle about his investments.
He said the markets were overheated, so he was going to “cut and run.” Take his profits now and get out before the inevitable happened.
That’s silly, I explained.
If the underlying companies are solid, then he should hold on. The stock prices will recover after a correction.
I told him that if I’d learned anything from working in this industry, it was that the market ultimately moves in only one direction: up.
As it turns out, we were both right… or both a little wrong, as the case may be.
I turned to my mentor for all things finance and investing, Chief Trends Strategist Matthew Carr.
There’s one detail I hadn’t properly factored in: risk tolerance.
I’m a young adult. I have exposure to long-term, high-risk, high-growth investments.
A market correction – or even a full-on bear market – would hardly make a dent in my retirement plans. It would be more of a speed bump than a pothole.
Whereas my uncle is in his mid-60s and nearing retirement. (Though I think he enjoys his work too much to take the plunge!)
For him, a correction could wipe out years of gains in the blink of an eye… gains that he won’t necessarily have time to recoup.
His portfolio should be low-risk with plenty of income generators like dividend-paying stocks and bonds.
Find Your Balance
Now, I said we were both right… and that’s true depending on your level of risk.
It’s a good idea to close out your highfliers when you think a peak has been hit, Matthew explained to me. This is one way to recoup your principal investment and play with the house’s money.
Closing out positions will also allow you to rebalance your portfolio. When your winners take off, your portfolio becomes overweight in those positions.
We typically recommend that any single position should account for only 4% of your portfolio. This is called position sizing.
But that 4% could turn into 20% of your portfolio’s value if the underlying stock takes off.
So taking profits – but not exiting the market completely – is one way to unload some positions and rebalance your portfolio while also keeping some skin in the game.
If you can withstand a little bit of risk, don’t close out a good position in anticipation of a fall that may or may not happen in the short term.
That kind of caution will end up hurting you in the long run.
The Ultimate Safety Net
Now, position sizing is just part of the answer.
Another important lesson is knowing when to let your winners run… and when to cut your losers short.
The safest, most surefire way to know when to get out of a position is to use exit stops.
I know… you’ve probably heard this before. But it’s worth repeating until I’m blue in the face.
When you enter a position, you should determine the price you will exit at, no questions asked, or – our preference here – set a trailing stop 25% below your entry price. That way, if you’re adhering to the 4% position sizing rule I outlined above, you can lose only 1% of your portfolio’s value.
Let’s say you had $2,500 to invest and wanted to buy “Best Stock Ever” using a trailing stop strategy. Following the 4% benchmark, you would put $100 in Best Stock Ever. If it lost 25% of its value and hit $75, you would sell. You would lose only $25.
So if the stock falls, you’re protected on the downside.
That’s small potatoes, right? Every investment carries risk, and 1% of your total portfolio is a recoupable loss.
But the best part about trailing stops is that they protect you on the upside as well.
As the stock price rises, that 25% stop follows.
If Best Stock Ever jumped to $150, your new stop price would be $112.50 – locking in a minimum 12.5% gain on your initial investment. And so on and so forth as the stock price increases.
Always Read the Safety Instructions
These rules take emotions out of the equation. Because emotions (especially panic) are the enemy of investors – both on the upside and on the downside.
Euphoria is just as dangerous as despondency. And that’s why we set up these guidelines from the get-go, before we get attached.
So… should you prepare for a correction or downturn by liquidating all your positions and stowing your cash under the mattress? No, absolutely not.
But you should have responsible safeguards in place to protect you.
In short, don’t hide in your house because you’re afraid of a storm. Instead, carry an umbrella in case you get caught in the rain.