By Jane Young, CFP, EA
After the drop in the stock market in mid-May, many investors became concerned that the market is ready for a major correction. No one can predict future movements in the stock market, although many analysts make claims to the contrary. There are many competing influences that cause the market to rise or fall.
Some factors that may boost the market include mass vaccinations, the re-opening of the economy, large stimulus payments, lower unemployment, and a stronger outlook for corporate profits as we recover from the pandemic. As the economy recovers and Americans start spending again, we should see a large surge in demand.
However, some of the same factors that help to boost the economy may have a negative impact on the stock market. There is concern that stimulus payments, increased government spending, increased demand and rising wages will increase the threat of inflation. Inflation along with concerns about higher individual and corporate income taxes, a more restrictive regulatory environment and on-going uncertainty around COVID-19 could put a damper on the stock market.
It is impossible to predict the future performance of the market. Corrections are a normal part of the investment cycle and if you invest in the stock market you will experience years with negative returns. With exception to the brief but significant drop in the market last Spring the market has been on an upward trajectory for the last 12 years. This creates some room for concern, and we should expect to see a correction sometime within the next several years. However, with exception to the great depression, the economy has recovered from every major drop within two years.
Rather than worry about the next market correction, focus on what you can control and manage your portfolio to meet your financial situation. Markets will rise and fall but your asset allocation should be based on your financial time horizon, your liquidity needs, the stability of your income and your tolerance for risk.
If you establish and maintain the right asset allocation for your situation you will not need to make changes when there is a market correction. You will have enough money in secure investments outside the stock market to cover expenses for the next five years along with any emergencies that may arise.
Once your emergency and liquidity needs are covered, consider your emotional tolerance to a market crash. The level of risk in your portfolio should allow you to calmly stick to your plan and ride out a major market correction. Panic selling after the market has dropped can be extremely detrimental to the long-term performance of your portfolio.
Create an allocation that is safe enough to stay the course during the next big crash but not so conservative that you miss opportunities for your portfolio to grow when the market rises.