How to Survive a Correction
Despite a rocky atmosphere surrounding President Trump during his first few days in office, the stock market moved higher in anticipation of improving economic growth as a result of his “America First” approach. All three of the major U.S. stock market indexes hit record highs last week, with the Dow Jones Industrial Average closing above 20,000 for the first time ever.
That is cause for celebration, especially on Wall Street, where bonuses are tied to short term performance. But it’s also reason for worry given our stock market—already overvalued by historical measures—has pushed even higher. You may be like many investors who are wondering: Do I invest now, or wait for a crash?
Waiting for the next crash can be a dangerous game, since they don’t occur as often as our fears predict, and we can lose by keeping cash on the sidelines awaiting a calamity that never occurs. But piling into the stock market after a huge run-up doesn’t seem to make much sense, either. So I advise a balanced portfolio and making smart choices when buying individual security to maximize gains while minimizing risks.
Recently I reduced my recommended allocation to stocks to 35%, which is the lowest it has been since I took over as Chief Investment Strategist for Personal Finance three years ago. The other 65% is allocated to cash, bonds and inflation hedges. If the stock market drops 20% and my equity portfolio does the same, then my overall account value is only reduced by 7%. That stings in the short run, but nowhere near a full 20% drubbing.
And if stocks do drop 20%, chances are I’ll make some of that back from my bonds and inflation hedges, depending on what set of economic conditions accompany the correction. More importantly, after the correction I can allocate some of that money back to stocks, and make back my loss more quickly when stocks come back.
If we do get a major stock market correction in 2017, then I will increase my stock market allocation to somewhere in the 50% to 75% range once I believe it has bottomed out. That’s about double my current allocation, meaning my gains will accumulate at twice the pace of my losses. That also means I will have less money in the other assets that provide diversification, so I am also increasing the portfolio’s overall volatility at the same time.
But that’s okay, provided I am smart about where I put that new money. Buying an index fund would ensure me of participating in the market’s average performance, which should be pretty good in the early stages of a recovery. A better strategy is buying stocks of companies that will grow at a faster pace than the overall market—but of course that’s easier said than done.
To do that, you need to have a system that can accurately predict with better than 50% reliability exactly which stocks those will be. Investing legends Warren Buffett and Peter Lynch have each observed that a “win rate” of 60% is enough to significantly outperform the market averages in the long run. That slight margin is all it takes to stack the odds strongly in your favor.
If you already know how to do that, you’re set. But if you don’t, then you should be careful about arbitrarily putting money into a highly-priced stock market. For that reason, we offer our readers access to a wide variety of portfolios, and investment strategies, to achieve their financial objectives regardless of the market.
After compiling the full year returns for both of Investing Daily’s flagship publications for 2016, I am proud to report that several of our portfolios handily beat their sector benchmarks. The portfolio I manage, the Personal Finance Growth Portfolio, delivered a total return of 12.4% in 2016, compared to 9.6% for the S&P 500 Index. However, that pales in comparison to the 23.9% gain Ari Charney racked up in the Utility Forecaster Growth Portfolio last year, and the 27.8% gain in its Income Portfolio.
If you can combine those types of returns with a sensible asset allocation strategy then it is never the wrong time to invest in the stock market.