October 19, 2021

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How to Prepare for a Market Correction | Investing 101

A market correction, which takes place when there’s a precipitous drop in the stock market, can seem like an investor’s worst nightmare. And while declines can actually be healthy, allowing markets to rebalance and readjust, that knowledge may be cold comfort to investors when it comes to the thought of losing money on their investments.

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Investors can overcome this unease by knowing how to prepare for a downturn in the markets, even when it’s unexpected.

Diversification among various stocks and asset classes can somewhat protect an investment portfolio against a market correction. But in this evolving and volatile market environment, how can investors know which stocks will position their investment portfolios properly?

What about other asset classes such as cryptocurrencies? Here is what you need to know about how to approach investments during a market correction:

  • What is a market correction?
  • How to treat stocks in a correction.
  • Stock technical analysis.
  • How to think about cryptocurrencies during a downturn.

What Is a Market Correction?

A market correction takes place when there is a sharp drop in the stock market. More specifically, a 10% decline in a broad measure of stocks from its highs within a short period. Market corrections are abrupt and can occur without warning.

Corrections are common following a period of positive market performance. Throughout 2021, investor optimism, along with the Federal Reserve’s accommodative monetary policy, has resulted in markets reaching all-time highs. Investors have piled into the markets, making profits during the bull market, and resulting in more money entering the markets, a cycle that could lead to overvaluation.

When investors see a window of opportunity to sell their overvalued shares for a profit, this trend can accelerate throughout the markets and cause a massive sell-off, leading to a correction.

How to Treat Stocks in a Market Correction

If your portfolio is heavily allocated toward stocks, you may be wondering what the best course is if a market correction is looming. Having a portfolio that’s properly balanced among stocks, bonds and any other asset classes according to risk tolerance can be a winning strategy, experts say.

Given that stocks have been performing well for the past decade, investors need to be “dialing back equity exposure and make sure they have a healthier weight to bonds” to guard against a pullback in stocks, says Donald Calcagni, chief investment officer at Mercer Advisors in Denver.

He adds, “Within equities, investors should be rebalancing their portfolio toward value stocks.”

As the economy struggles to emerge from the coronavirus pandemic and interest rates rise, value stocks may outperform growth stocks.

These growth stocks, such as Facebook Inc. (ticker: FB), Amazon.com Inc. (AMZN) and Alphabet Inc. (GOOG, GOOGL), have had an amazing run during the course of the pandemic. Investors in Invesco’s QQQ Trust ETF (QQQ), which holds Facebook, Alphabet and Amazon.com along with other big tech names, have seen it soar about 100% since the darkest days of the pandemic.

Now may be the time for investors to pocket some of their gains and rebalance toward a value mutual fund or value exchange-traded fund, Calcagni says.

He lists three reasons offloading growth names could be the right call.

First, valuations are sky-high. “If you don’t sell stocks now, then when?” Calcagni asks. The S&P 500’s price-to-earnings ratio is near 35, elevated by historical standards.

Second, Calcagni says, there are opportunities in the market, such as value plays or non-U.S. stocks, that offer better deals than U.S. growth stocks. “Non-U.S. stocks look very attractive on a valuation basis relative to U.S. stocks,” Calcagni says. “At least 30% of (investors’) stock portfolio should be non-U.S. stocks.”

Third, the expectation is that capital gains taxes will be higher in the future.

“It makes sense to lock in today’s lower capital gains rates (by selling) rather than hold a stock and end up selling it (in) the future at a much higher capital gains rate,” Calcagni says.

Do Your Stock Technical Analysis

Reviewing the technicals of a stock can offer helpful insights into how the stock performed in similar market conditions and what investors can anticipate looking ahead.

Technical analysis involves reviewing historical stock performance data and volume as a way to forecast the direction of a stock’s price. Technical analysis can help investors seeking to identify overvalued stocks and exit their positions before a market correction.

Indicators including price gaps, volume shelves and moving averages can give clues into the future, says Jake Wujastyk, chief market analyst at TrendSpider, a technical analysis software firm.

“Look at the charts and historical price action to get an idea of what the average move down has been in the past, based on different technical conditions,” Wujastyk says.

This kind of careful preparation can help savvy investors weather a correction. In fact, investors with a long-term mindset should welcome corrections, Wujastyk says.

This is a time “to dollar-cost-average into positions they currently have and/or look at finding stocks they have been watching to start positions,” Wujastyk says. Dollar-cost averaging is a technique where investors allocate funds to an investment in regular intervals over time. This method can blunt the effect of volatility.

What About Cryptocurrencies?

When an asset drops by more than 10%, that’s considered a correction, and investors may become concerned about a potential crash.

This drop could also cause a stir in the crypto markets. But investors should have perspective: For cryptocurrencies such as Bitcoin, a 10% drop is just another day in the markets.

The crypto market is more sensitive to global events because cryptocurrencies are a fledgling asset class, are targets of speculation, remain supported by an evolving technology and are still a relatively new concept to investors.

Investors shouldn’t necessarily be viewing the peaks and troughs of the crypto market as in sync with the equity markets.

While corrections tend to reverberate across markets, it’s difficult to find that correlation to the crypto markets, says Chris Kline, founder and chief operating officer of Bitcoin IRA, a cryptocurrency retirement platform based in Los Angeles.

Given that cryptocurrencies have only been around for a short period, there hasn’t been enough time to see how they perform when there are corrections in the equity markets.

There is a major difference between a Bitcoin crash and a correction in the stock market: the rate at which cryptocurrencies recover from a downturn compared to equities. Cryptocurrencies have recovered more quickly than stocks historically have.

“If you look back at what happened in March 2020 and which assets moved faster in recovery, crypto was leading that way,” Kline says.

Crypto investors may be used to volatility. But with the sell-off in the equity markets earlier in September and the most recent 10% drop in Bitcoin, anyone may be concerned, especially those who have part of their retirement in Bitcoin.

But just like with equities, investors can prepare for significant drops in the crypto market. Some crypto investors use the asset as a nest egg and have a long-term investing mindset, with a minimum three- to five-year timeline, instead of jumping in and out of the markets, Kline says.

“If you begin with the end in mind, you will have a more likable result based upon your expectations,” he says.

During dips in cryptocurrencies, Kline says, you tend to see a “trend of accumulation,” where investors see drops in crypto prices as buying opportunities, whether it be Bitcoin or alternative coins.

Takeaway

It can be stressful to think about how a market correction can result in losing money on your investments. But knowing that market downturns are a temporary feature of the stock market, you can prepare for such an event. It may not be an insurmountable challenge to weather a temporary market drop, especially with a long-term investment plan.

https://money.usnews.com/investing/investing-101/articles/how-to-prepare-for-a-market-correction