What Can I Do to Protect My Investments From a Market Downturn?

Nobody likes bad news, but sometimes in the stock markets, it’s inevitable. It’s also natural — markets and economies go through cycles of boom and bust. For every bull market that we enjoy, there’s likely to be a bear lurking somewhere in the future. Because of this, it’s important to have a plan in place in case of a downturn.

So what should you do when a bear market looks imminent?

Don’t Throw Out Your Stocks

The worst possible strategy whenever the market starts to turn downward would be either to liquidate your portfolio or — worse — to begin taking short positions. This market has punished investors who have become overly bearish.

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Instead, there’s a strong case for maintaining a significant portion of your investment portfolio in stocks, even if the market becomes volatile. That’s because you will want to be in position to take advantage of any forward motion the market produces. However, you’ll want to make sure that your portfolio is as armored against negative market forces as possible.

“Prune” Your Stock Portfolio

There are ways that you can reduce your overall stock exposure without hurting the core strengths in your portfolio.

Sell positions that haven’t done well. If you are holding stocks or funds in your portfolio that have not done well in a recent boom, they can be among the worst hit in a correction or a protracted downturn.

Don’t be afraid to take profits here and there. If you have some positions that have done extraordinarily well, and that you no longer have as much confidence in, it’s OK to take profits. That’s always best done at market peaks. Even if you miss out on future gains, you’ll have locked in some nice profits.

Change the Way You Invest in Stocks

Recent bull markets have seen a surge in index investing. When this happens, investors pour money into index-based ETFs and simply ride the market up. While this type of investing works particularly well during steady bull markets, bear markets are less reliable. The best-performing investments are likely to be isolated situations.

Examples include:

Focus on companies with strong growth. Bull markets can cause the stock of even marginal companies to turn positive results. But weaker markets tend to favor companies with the strongest growth records.Dividends matter. Should the market begin to reverse, income will become more important. Favor stocks in strong companies with above average dividend yields.Look for special situations. While bull markets tend to favor the winners, bear markets often bring renewed interest in value stocks. These are stocks that have not performed well, despite the fact that the companies behind them are fundamentally solid.Become more selective. Bear markets often bring about changes in market leadership. Keep a close eye on the shifts, particularly when you become aware of changes by institutional money managers.

Start Increasing Your Cash Position

Cash serves two primary advantages in bear markets. The first is to reduce volatility in your portfolio. Since cash investments are the type that have no risk of principle, they represent the one corner of your portfolio that will at least hold its value during times of volatility.

The second advantage is that a large cash position prepares you to take advantage of new investment situations going forward. The more cash you have, the better you will be able to position yourself to changing market conditions.

How can you raise cash, short of selling stocks wholesale?

Direct new contributions into cash investments. You can build up your cash position just by keeping any new contributions liquid. Money market funds are perfect for this purpose. You can raise cash simply by not buying new stock.Hold money from your portfolio pruning in cash. While you can move some of that cash into new opportunities, at least some of it should be redirected into cash.Save windfalls. Tax refunds, sales of personal assets and bonuses can be accumulated in cash positions for future use.

Strategies Beyond Your Investment Portfolio

It’s an unfortunate reality that declines in the stock market often parallel declines in the economy. For example, the last two stock market crashes were accompanied by deep recessions — the dot-com bust and the Financial Meltdown, aka The Great Recession. It’s not a coincidence.

A prolonged decline in stocks is often caused by the onset of a recession, while the recession itself is made worse by the decline in stocks. That’s an eventuality that also needs to be prepared for.

Raising cash is a sound strategy, not only to prepare for a market decline but also for a recession. The people who survive recessions the best are typically those who are most liquid. Raising cash is an obvious way to increase your liquidity. But there are other strategies as well.

For example, lowering your cost of living can help on a number of fronts. It can help insulate you from a reduction in income in the forms of less bonus, commission or overtime income. It could also help you to build your cash reserves.

Debt reduction is another excellent strategy. Most people wait until a recession is actually under way before making serious efforts to get out of debt. But if you can get started on that process now, you’ll be in a better position as potential negative events unfold.

The Big Picture — Preparing for the Next Leg Up

Advance preparation is always an excellent strategy, regardless of what economic or financial headwinds you expect in the future.

With regard to the stock market, lowering your exposure during a market peak only makes sense. So does building your cash reserves. Sooner or later, this market will experience a significant decline. Once it does, the more cash you have available, the more opportunities you will be able to take advantage of.

While it’s tempting to always believe that a given bull market can continue forever, reality always has other plans for us. Whenever markets hit new highs, the likelihood of a major decline increases. Preparing for it doesn’t make it happen — but it does put you in an improved position once it does.

Everyone has to decide for themselves where they think the market will be heading in the next two or three years. Look at the market, and then look closely at the economy and the international and domestic political situations, as well as interest rates. If you believe that the market has become overheated — which is an excellent assumption after years of steady increases — prepare accordingly.