When it comes to stock market crashes and bear markets, the legendary Warren Buffett said it best: 'Only when the tide goes out do you discover who's been swimming naked.'
He's right. We investors are all too happy to keep our 401ks and investment portfolios just as they are while reaping year-after-year of healthy bull market returns. It's only when the Dow suffers a frightening 800 point plunge are we caught unprepared for what to do (or not to do) next with our investments.
These market downturns are not to be taken lightly, as hastily selling stock or moving into overly-conservative investments can set you back years or even decades toward your retirement goals if you're not careful.
So what should you do if there's a big market correction or if a bear market is truly here for the next several months? Start by following these five steps to avoid the perils of 'swimming naked.'
1. Do Nothing
Today's 24/7 Internet-fueled news cycle has a way of exaggerating certain events. Be skeptical of the hyperbolic analysis of self-appointed 'experts' who weigh in with their opinions as to why the market dropped. When you hear or read pundits opining about the latest market calamity, ask yourself, 'If they're so smart, why didn't they see this coming?'
When in doubt, doing nothing is usually your best bet. Investors typically act too quickly to a big drop in the market -- and they almost always do the wrong thing. Control your emotions and see how events pan out. To quote a Wall Street adage, 'Never sell into the market weakness.'
The market decline might be a short-lived aberration. Study the reasons behind the sudden change and you might find that the fundamentals of the market remain sound. For example, the 'correction' might not be a correction at all, but simply an overreaction to a sensational story of the week. If so, sit tight. The market will soon bounce back.
2. Diversify Your Holdings
Maybe your own analysis tells you that legitimate reasons are behind the decline -- say, a series of genuinely lousy corporate earnings report combined with a sharp increase in unemployment applications.
If that's the case, you're justified in taking modest action. Ideally, you're already partially protected by diversification. If not, then consider diversifying your money among various categories of stocks, bonds, interest-earning investments, and real estate, and other asset classes.
[For help, check out Diversification: The Beginner's Guide to Protecting Your Nest Egg]
3. Remember Your Long-Term Goals
Chances are you're saving for retirement or for another long-term goal. With that in mind, keep your eye on the long game. Don't panic and throw your investment strategy out the window.
Stick to your original goals that you set up when you started your portfolio or get help from a financial advisor. When the markets recover, you’ll be in a good position to pick up right where you left off.
4. Make Small Adjustments to Your Allocations
Too many investors tend to overreact and abandon a certain asset class because it tanked this time. Don't make this mistake! The biggest risk is that you might sell your legitimately good stocks right before they recover. And if you implement a drastic change in your allocations, it's much harder to go back to your original investment-allocation strategy.
Instead, make minor -- repeat, minor -- adjustments to your portfolio allocations. For example, if your current allocation is 70% stocks, and stocks suddenly tank, consider reducing your stock allocation to 60% and making up the difference in bonds. That way you can take a defensive position while you ride out the downturn until market certainty returns.
[See how to protect your portfolio through asset allocation to reach your long-term goals]
5. Sell Overpriced Cyclical Stocks
If the crash is related to underlying economic conditions, consider selling only those cyclical stocks that are the weakest and reallocating the money into your non-cyclical stocks.
Restrict your selling to the ones that are overpriced and vulnerable to further drops. Be sure to hang onto those that are at reasonable or bargain valuations -- they might justify additional investment when the market regains its sanity.
Big market declines are not uncommon. In fact, they're inevitable. When the market does suddenly dry up on you, it's important to trust your research and remember your long-term goals. This way, you're sure to make it to dry land.