How to Protect Your Investments When The Market Drops
Updated: Jun 9, 2020
Given that the coronavirus fears gave us one of the worst weeks since the financial crisis, the investing community – and top hedge fund managers too – are unsure how long the markets will have to endure this.
Moreover, new investors are scrambling to protect their money, but the question is, how do we do that in such dynamic market conditions?
The most effective way would be to start by understanding the numbers behind market corrections and then proceeding to reallocate your money into safer assets. First, let us delve into the statistics of such market drops.
1. Average Market Drop
A “correction”, as mentioned above, is a period of time whereby the market (key indices such as the S&P500, DJ30, and NASDAQ100) drop by at least 10% from their all-time highs. For example, if the S&P’s all-time high is 3,386 points and we’re now sitting around the 2,970 area, this is a drop of 12.28%.
Figure 1: S&P500 Chart Drop
Source: (Google Finance, 2020)
Since this dip is larger than 10%, we – as investors – say that we’re now in correction territory. The question is, where do we go from here?
According to Tony Robbins’ book, Unshakeable, a correction occurs once every year on average, with a usual market drop of about 14%. Optimistically, this means that we not only haven’t even reached the average drawdown yet, but also that a sudden drop like this is almost completely normal.
Seasoned investors tend to be familiar with these statistics and prepare for such events (buying safe assets such as gold, US Treasuries); but even more so, they see it as pure opportunity. The issue arises when it comes to beginner investors, as such market falls give rise to panic…a lot of panic.
This is why understanding how corrections work is important, as new investors may get a more solid grounding of where the market stands. For example, consider beginner Michael's thought process:
If we’re currently at a 12.3% correction and the average is 14%, it seems plausible that there is room for a further drop. Knowing this, opening any new positions during a period of turmoil may not be profitable, and would, therefore, prevent me from protecting my money. Instead, once the market settles down, I could buy stocks at lower prices and maximize my profitability later on.
Understanding the numbers behind market corrections will allow new investors to familiarize themselves with this kind of thought process, and will guide them in realizing their exposure and planing any future investments.
2. Average Correction Time Period
Referencing the same book, Unshakeable interviews 50 of the foremost minds in finance – including Warren Buffet, Ray Dalio, Jack Bogle, Alan Greenspan and more – to conclude that most corrections last an average of 54 days.
This means that - for just under two months - we could be experiencing low growth in the stock market as well as some unfavorable pullbacks.
Given this timeframe, however, investors have a certain range that they can keep in mind before opening any new positions. I.e. if we’re only on Day 10 of a correction period, it may be more beneficial to wait before investing again, as there is a possibility of more volatility and stagnant growth.
Key Point: While the generalized period of 54 days is relatively accepted, it’s important to consider that it may not be exact.
Figure 2: Time Taken To Enter Correction Stage
Source: (Bloomberg, 2020)
As depicted above, the latest correction was far quicker than most others: i.e. the S&P500 lost over 10% within 6 days. Such an unprecedented drop could imply two things:
a) Either the current correction could finish quite quickly as well (in less than 54 days), and we can see the market picking up again soon (especially since the Federal Reserve is ready to step in and stabilize the market). Or;
b) The poor market conditions suggest an even further deterioration, which means we could be seeing the market dropping over 20% (if the virus becomes a pandemic). This is indicative of recessionary behavior (i.e. a bear market), and is something that investors will be keeping a close eye on.
So…what can new investors do in this scenario?
According to the foremost minds in finance, the spread of COVID-19 yields complete uncertainty in the markets. If even Ray Dalio – one of the world’s most successful investors – calls himself a “dumb shit” in matters like this, it seems difficult for regular profit-seekers – such as you and I – to predict what’s coming.
Instead, it’s perhaps more optimal to understand the aforementioned statistics and keep cash aside. Markets in correction mean that your favorite stocks essentially go on discount, which is when investors with back-up cash can feast on these profitable opportunities.
By monitoring the news, understanding the basics of corrections and being patient, new investors will be able to overcome the initial panic associated with market drops, and see it as an opportunity for further growth instead.
This is the mindset held by the most successful people in investing, and it's one that we could benefit from adopting too!