1. Keep new cash out of equities
If you have been pouring money into stocks over the past few years to take advantage of perpetually rising values, cutting off those purchases is a necessary step. In this way, you limit your exposure to equities going forward.
It is far less necessary, and generally undesirable, to begin a wholesale liquidation of your equity positions. This is because no one can know the timing of a market decline, or how severe it will be. If you liquidate all of your equities and the market declines by 10% — followed by a quick 20% run higher — you'll miss out on the rally.
Even in a downturn, it never makes sense to be completely out of the stock market.
2. Build up your cash reserves
Cash is probably the best place to be during a downturn in the market. This is because typical cash investments don’t lose value during market declines, even if the interest rate returns they provide are puny.
The idea is to begin increasing your cash position in order to reduce the overall volatility of your portfolio. Holding cash means that at least some of your assets are safe from declines. And nothing is more valuable at the end of a market downturn than a large cash position. Money market funds, certificates of deposit or U.S. Treasury bills are your best cash shelters — you don’t need anything fancy.
3. Be careful with bonds
There is a general belief that bonds represent a counterbalance to stocks. While that can be true in certain types of market downturns — deflation certainly comes to mind — it’s also true that stocks and bonds often move in tandem. And just as the same factors that cause stock prices to rise also cause bond prices to rise, a driver that hurts stocks could also hurt bonds. Think rising interest rates, or even inflation.
It’s important to understand, especially during a market downturn, that long-term bonds in particular do not offer any protection of principal, unless the bonds are held until maturity. Should market forces cause bond prices to drop, the value of your bond holdings will also fall and provide no real diversification from stocks.
4. Check out real estate investment trusts
Real estate investment trusts, or REITs, can be an excellent alternative to stocks, particularly during a market downturn. This is at least partially because the real estate market moves more slowly than the stock market does. As well, the real estate market could be running on its own trajectory, completely independent of stocks.
For example, it is possible that real estate can be a poor investment during a bull market in stocks, but if stocks were to reverse, real estate could increase as money flees the stock market and looks for tangible investments in real assets.
In the current market environment, REITs offer higher yields than most stocks, and that income could be a welcome cash flow in an otherwise uncertain financial environment.
5. Sell equities selectively
Once again, selling off stocks wholesale in anticipation of a market decline is usually a losing strategy. However, a market top is an excellent place to begin selling off stocks on a selected basis.
However, you may want to get out of what analysts often call “laggards” — stocks that are underperforming. If the stock has not performed well after more than six years of a bull market, it’s probably good to get out of it before a market decline brings it down even more. You may also have some stocks that have performed very well, but either the fundamentals are beginning to look shaky or you may see a change in market dynamics that may no longer favor a particular company or sector.
Preparing for a market downturn is an excellent reason to begin pruning your portfolio of any stocks that are remotely suspect. And as for the rest of your holdings, as long as they are fundamentally sound, they should be worth holding.
6. Focus on high-dividend stocks
High-dividend stocks aren’t immune to market downturns, but the yields they provide will enable you to ride out a market downturn while continuing to receive a generous cash flow from the investment. That will make them more logical to hold during a protracted decline than perhaps a pure growth stock that pays no dividends at all.
In addition, as stock prices decline, the yield on dividend stocks will increase. Yields could reach a level that will bring in new waves of investors seeking higher returns on their money. That could make high-dividend stocks among the first equities to stage a comeback in the next bull market.
7. Take action while values are still high
In order for a market downturn strategy to work, you’ll have to begin making changes in your portfolio before a downturn becomes obvious to the general market. If you don’t start taking action until the market is down by, say, 20%, your portfolio will have already lost a significant amount of its value. And after that, you may find yourself chasing your equities lower, always hoping for a bounce that will make selling them more attractive.
It’s also especially important that you begin building your cash reserves before the decline. You want to make sure that your cash position is high by the time the market reaches its bottom. If you wait until the market decline is already well under way, you may not have enough time to accumulate the kind of cash that you will need once the market stabilizes.
8. View declines as potential buying opportunities
A downturn in stocks should never be viewed as a signal to run for the hills. Instead, it should be treated as the perfect opportunity to pre-position your portfolio for the next bull market. Any investment opportunity that looks good today will be even better after the market has taken a significant haircut.
Market downturns, especially severe ones, tend to take down almost all stocks — both the good and the bad. By making significant adjustments in your portfolio before the downturn hits, you will be in an excellent position to ride the next market wave up, early in the game when the investment opportunities will be the richest.