How to Arm Yourself for the Next Market Downturn

“The key to making money in stocks is not to get scared out of them.” – Peter Lynch

The recent turbulence in the stock market has thrown a lot of investors off their game. And if you’re one of them, I bet you want to know why it’s happening. It takes hours out of your day to wade through all the newspapers and magazines, but it’s important to have a better understanding of what’s going on, right?

Forgive me for saying so, but you’re on a fool’s quest. I suspect it’s not the thirst for knowledge that’s driving you. You’re not even doing it out of concern for the safety of your savings. And if you really think you can figure out what’s going to happen tomorrow by understanding what happened yesterday, you’re a lot more optimistic than you should be.

What it really comes down to is this: The up-and-down swings of the market have thrown you out of your comfort range, and you want it back.

Admit it. We’re creatures of habit. We know what we like and we like what we know … even if what we know is a down market.

As perverse as it may seem, I really think we’d prefer the market to just make up its mind and head downhill. That way, at least we’d know what to do with our portfolios.

Yes, there’s already been a flight to quality, but not yet a mad or massive rush to bonds. Yes, bond prices were up immediately following that three percent drop in early March, but a movement toward bonds is to be expected in such circumstances. And bonds have since been trading up and down, depending on the news of the day. That doesn’t tell us much.

So, right about now, you have a choice.

You can continue agonizing over the state of the global and U.S. markets. I call that avoidance.

If you’re into Zen meditation, you can try contemplating the difference between post-recovery mild growth and a pre-recession mild slowdown. I call that a plain waste of time.

Or you can hunker down with your portfolio and take what’s happened during the past month and a half as a warning shot. Call it a test run for your portfolio because, regardless of what you think may happen tomorrow, you could be wrong. And unless your prediction is that the bottom is about to drop out of the market, your crystal ball could spell deep trouble for your portfolio.

In other words, you need to seek shelter against a storm before it hits.

Do me a favor and spend some serious time with your portfolio now. Experience is the best teacher, and you’ve been handed a benign version of market hell. Was your portfolio up to the challenge? Did any of your holdings go up? Which ones took a nosedive?

A market dropping about three percent is a mere ripple, a mini-correction. A proper correction is defined as at least a 10 percent drop. The next time the market falls, it could be a lot worse and your portfolio could take a much harder hit.

It’s possible that we’ve seen the worst of it – but I’m waiting for the other shoe to drop. And your portfolio should be ready if it does.

When the market corrects during broad upswings, it usually does it in two stages. The first downshift is usually followed by a second or “capitulation” downshift. We saw this pattern last May and June and in April 2005.

Now is the time for you to figure out exactly how correction-resistant your investments are. Here’s how I’d do it:

1. Divide your portfolio into its broadest categories – along the lines of stocks, bonds, commodities, and “special” investments (collectibles, jewelry, etc.). Determine how each category did during the recent mini-correction. That is, how much it lost from February 27th through the first few days of March, and how much it’s recovered since.

2. Break down your stocks further by risk factor. Blue chips, dividend-paying, and mid-to-large-cap value belong in the lowest-risk group. Growth, Canadian, west-European stocks, and small caps make up the next group. Emerging-country and central-European stocks go into the third group. And micro-caps, penny stocks, and IPOs constitute the riskiest group. I’d also separate out real estate by putting all REITs and other real-estate stocks into their own group.

Line up your bonds in this order: government bonds, munis, government agency bonds, corporate, and junk. If you have bond funds, see what their main holdings are and line them up accordingly.

Group your commodities (if you have any) by precious and non-precious metals, energy, grains, and other “soft” commodities like cotton, cocoa, or coffee. And put your collectibles to the side for now. (Believe me, they’re doing fine.)

3. At this point, you should have a good idea of just how far down the risk continuum your stock and bond holdings have been affected. For your commodities, simply get a general sense of how they did. For example, it’s worth noting that gold didn’t offer any protection. When the market slipped, the price of gold also went down, although it has since rallied.

4. Now you’re ready to make some changes. Return to step one and adjust your asset allocation by rewarding the broad categories that did well and cutting back on those that fared poorly. Then go through your individual holdings and do the same thing.

Assume the worst. Imagine that your portfolio is about to get hit not by gusty winds but by a cyclone. Do more hedging. Get more protection. Don’t give up on gold, but at least realize that gold might not be the protection you thought it would be. It needs help in the form of something like the PowerShare ETFs that short the market and the dollar. And for those stocks you choose to keep, enact a strategy of locking in returns earlier than usual.

When you’re done, your portfolio will undoubtedly have less upside potential. But it will also have much more resilience during a market downturn.

If the worst happens, you won’t escape unscathed. But you’ll do a lot better than 98 percent of other investors. And that’s all you can ask for.

[Ed. Note: Andrew Gordon, ETR’s financial expert, is the editor of INCOME.  Each month, he uncovers income-generating stocks that promise safety (first and foremost), along with much higher-than-average profit potential.]