Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Five Ways to Survive a Severe Market Decline

Let's assume that the investment tide suddenly receded at a frightening pace -- say, in the form of a one-day drop of more than 800 points in the Dow Jones Industrial Average. What would you do?

The legendary Warren Buffett said it best: "Only when the tide goes out do you discover who’s been swimming naked." Be prepared for these inevitable ebbs and flows -- or get caught with your swimming trunks down.

Here are five ways to survive the perils of swimming naked.

Do Nothing

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 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.

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?"

[Investing Answers Feature: Three Ways to Play the Market's Volatility.]

If You Haven't Already, Diversify Your Holdings

Maybe your own analysis tells you that legitimate reasons are behind the decline -- say, a genuinely lousy corporate earnings report that's combined with an increase in applications for unemployment insurance. If that's the case, you're justified in taking modest action. Ideally, you're already partially protected by diversification. If not, then increase your diversification among various categories of stocks, bonds, interest-earning investments, real estate, etc.

[Investing Answers Feature: What Diversification Is and Why You Need to Embrace It.]

Remember Your Long-Term Goals

Chances are you're saving for retirement or for another long-range 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. When the markets recover, you’ll be in a good position to pick up right where you left off.
 
Make Minor Modifications to Your Allocations

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. But don't follow the mistake of many investors, who overreact to the sudden decline in a certain category by completely abandoning it.

Resist the urge to make wild swings in your allocations; the risk is that you might sell your stocks right before they recover. If you implement a drastic change in your allocations, it’s much harder to go back to your original investment-allocation strategy.

[More: Learn how to protect your portfolio through asset allocation to reach your long-term goals.]

Sell Overpriced Cyclicals

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.

Precipitous market drops 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.