The Best Way to Survive a Market Meltdown

How should you be reacting to a market meltdown? With a stock market that’s closing in on its eighth year of positive returns, why would I even be talking about this? I don’t want to jinx anything, but investing is sort of like gravity: What goes up must come down. So, we all know that markets go up and markets go down. Sometimes suddenly and deeply. Before you jump off a cliff when the inevitable happens, take a deep breath and remember that how you decide to react to a market meltdown will make a big difference to your bottom line now and later.

Rarely is it a good idea to panic. Investing is a lot about two emotions: fear and greed. Those who end up following their gut and react out of fear may very well be taken advantage of by those who have been led by greed. Like most other things in life, having a plan of action can make a world of difference. Reacting to a market meltdown is no different. And having a plan for life or your money (or both) will help you avoid being driven to madness by your emotions.

A Perceived Slowdown in China's Economy

Let’s remember it was bound to happen. Eventually, there had to be something to tip over the bull that has been roaring (and sometimes more recently limping) along since the Great Recession. The ostensible reason now is a perceived slowdown in China’s economy. Given global trading patterns, this has sparked a rout in the market for risky assets, a market already fearful because of turmoil in Greece and almost daily fear-instilling images of terrorist acts.

And despite the solid performance of many stock markets since the nadir of the Great Recession, this recovery has always been a little different.  Investors have stayed away from the punch bowl and kept a lot in cash. No amount of positive economic data has eased their jitters about the inevitability of the proverbial other shoe dropping that would prove once again how bad the market really is.

Stock Markets Are Full of Emotions

What is fear? There is an acronym that describes it well: FEAR (false evidence appearing real).

Behind all the computer algorithms, high-sounding research theories and a veneer of scientific precision, stock markets are petri dishes full of emotions. Right now, the pendulum has swung from complacency to a wild tempo metronome as fearful investors rush to dump assets and head for the exits. (For related reading, see: The Financial Markets: When Fear and Greed Take Over.)

There are certainly valid reasons for the financial prospects of certain industries, sectors (can you say oil?) or companies to be down at this stage of the market cycle or even in reaction to certain near-term news events, like China or Greece, before this. But this is not the end of the world as we know it. Short of hearing that a comet is on a collision course with Earth, I don’t see this as coming close to an extinction-level event.

Market volatility resulting in lower market prices is not the same as lower values for the underlying businesses represented by the stocks you own. In fact, the underlying values and fundamentals of many companies and hard assets have not changed even though the market has dropped. Think a moment: Did the value of your home go down because something happened in China or Greece? Unless you actually need money, this is actually an opportunity to buy good companies on sale.

Protect Your Nest Egg With a Plan

In many ways this is similar to what Yogi Bera said, “Like deja vu all over again.” The point I made in the article, Investing When the Sky is Falling, is also true. You can protect your nest egg when you have a plan. If you know where you need to be, it’s easier to stay on course or make corrections without succumbing to emotions.

You can protect your nest egg when you diversify. Research and common sense still show you’re better off when you don’t have all your eggs in one basket.

You can protect your nest egg by holding cash.There’s value in ‘keeping your powder dry’ to fight another day or take advantage of opportunities when investments go on sale after a market correction.

You can also protect your nest egg when you employ a dynamic investment strategy. Instead of simply following a "buy-hold-pray" strategy or a more emotionally driven approach reacting to your baser instincts of greed or fear, I recommend using a more rules-based approach to investment changes.

And you should always keep an eye on costs. Using lower-cost investments means you’ll have less drag and won’t need as heavy a lift to get back to break-even. Two of the cheapest options are index mutual funds and exchange-traded funds (ETFs).

Check Your Allocation and Cash Reserves

Now is a good time to check your asset allocation and replenish your day-to-day cash reserves by selectively pruning, not by blindly selling. To avoid being forced to sell to raise cash for near-term living expenses, utilize a "retirement bucket" approach. By setting aside several months’ worth of expenses in cash (for a more risk tolerant investor) up to two years’ worth (for a more conservative retired investor), you can ride out the inevitable storms without locking in losses, which happens when you sell during market downturns. (For related reading, see: How Much Cash Should I Keep in the Bank?)

Know When Not to Take Action

Sometimes we’re tempted to "do something" when confronted by a crisis. But sometimes, when the choice is between no action or shooting oneself in the foot, no action should be the winner. Yes, there’s room in between those extremes to tidy things up and shore up your positions (see above), but wholesale changes to your plan will produce a ripple effect downstream. In the near-term you could be in for a huge tax headache if selling out of positions with capital gains in your taxable accounts. In the longer term, you could be setting yourself up to be off-course.

Even the most conservative investor needs to understand that stocks are their friends in the long run to help outpace the adverse impact of inflation.  Holding too much of your portfolio in cash or bonds may provide some protection from short-term volatility but neither will help pay the bills for a retirement that may be longer than their working years. (For more from this author, see: Loser Stocks: Should I Stay or Should I Sell Now?)

And if you sell out now thinking you’ll get back in "when the market’s right" or prices turn around, you’re probably deluding yourself. Hindsight is perfect. Seeing the future isn’t. And unless you’re doing this full-time (and even then, it’s questionable), you’ll probably not get back in "at the right time." In fact, research on market performance shows that being out of the stock market for a small number of the best market days after a downturn has been hazardous to your long-term wealth.

Identify Your Risk Number

Your goal should be to build a globally diversified, tax-efficient portfolio that combines management investment styles to protect your portfolio on the downside. The best way to help align that portfolio with your long-term goals is to know your risk number.

Risk means different things to different investors, but most investors feel the pain of loss more than the loss of an opportunity or even the thrill of a gain.

A financial advisor can help you identify your risk number. Why is your risk number important? You’ll know exactly what kind of investor you are, what your comfort level is for loss and see for sure if the near-term reduction in your investments is really derailing your plans.

You’ll also be able to see if your portfolio is truly matched to your risk number. If you find that your risk number is 42, that translates to a loss range that you should be OK with of -7%. But if you’re invested like an 88 which means you should be OK with a loss up to -21%, then you’re likely in the wrong portfolio. In this case, you (and your advisor) should change your asset allocation. (For related reading, see: Risk and Diversification.)

Diversification Helps Protect Bottom Lines

Market meltdowns are scary. But we have to remember that what goes up must come down. And there’s no free lunch in life or in the markets. We expect long-term returns on stocks to be higher than cash or bonds, but that comes with volatility.

At times like these, our takeaway is the importance of diversification to help protect our bottom lines.

Another lesson is that if you have a plan in place—one that includes knowing your true risk tolerance, reflects your goals and provides for a rules-based investment system to make changes to your allocations—you’re more likely to weather the storm and stay on course.

(For more from this author, see: Investing in Gold? Here's What You Need to Know.)