Preparing Your Finances for a Market Correction

By Jane Young, CFP, EA

It is impossible to predict a market correction so it is essential to manage your finances and maintain a portfolio that can withstand significant market fluctuations. Although we do not know what the future holds, this is especially important right now because the S&P 500 has performed exceptionally well since 2009, with an average of annual return of 13.9% annually over the last ten years.

Rather than focus on outside forces that cannot be controlled, focus on what you can personally do to protect your money and gain more flexibility. Reduce consumer debt and identify unnecessary spending that you can reduce during a market downturn. Review your budget to ensure you spend less than you earn and that your spending aligns with your financial goals.

Establish and maintain an emergency fund equivalent to at least four months of expenses. This should be higher if your income is variable or uncertain. Keep enough money in cash to cover your liquidity needs over the next twelve months – your emergency fund plus your projected expenses, less income.

Create a diversified portfolio with an asset allocation designed to meet your long-term financial goals. Your asset allocation specifies the target percentage you want to invest in stock, bonds, and cash. Within the stock portion of your portfolio, you also need to diversify across different industries, geographies, and sizes of companies.

Your asset allocation is a long-term strategy and it should reflect your long-term investment goals, tolerance for risk, and financial timeframe. It may be appropriate to adjust your asset allocation overtime when you experience major life transitions but do not change your asset allocation based on concerns about short term market changes or to time the market.

Your portfolio should be safe enough to avoid the temptation to sell during a major market correction. However, security must be balanced with the need to take enough risk to grow your portfolio to meet financial goals and keep pace with inflation. To avoid the necessity of selling stock during a major correction, the fixed income portion of your portfolio should cover at least five to seven years of spending needs.

Your asset allocation is unique to your situation but a typical allocation for a retiree is around 40% in fixed income and 60% in stock market assets.

Once you establish a well-diversified portfolio, you need to review your portfolio periodically to be sure it stays aligned with your target asset allocation. Rebalance on an annual basis or when a major market swing pushes your portfolio out of balance by more than 5% to 10%. Rebalancing enables you to lock-in profits when the market has risen substantially and buy at a discount when the market has experienced a major correction.

While it is painful to experience a major market downturn, with a little planning and patience, you can confidently ride through a correction with less stress and minimal impact to the long-term performance of your portfolio.