Stock Market Downturns are Inevitable - Here's How to Overcome Them
Updated: Sep 11
Summary
Stock market declines are an unavoidable part of investing. The difficult part isn’t knowing that downturns will happen. It’s knowing how you will respond if your portfolio falls 20%, 30%, or even 40% while headlines are telling you that things could get worse. The investors who are best positioned to navigate a downturn aren’t generally the ones who successfully predicted it. They are the ones who prepared for it in advance. A thoughtful plan can help you avoid making emotional decisions, protect liquidity for near-term financial needs, identify opportunities when markets decline, and keep on track to achieve your long-term financial goals.
You Can’t Predict the Next Stock Market Downturn, But You Can Prepare for One
Even when the stock market is doing well and the economy is strong, the market is always climbing a wall of worry, and there will always be reasons to believe a market decline is imminent. Valuations may appear elevated. Interest rates may be changing. Inflation may remain persistent. Geopolitical risks may increase. Economic growth may weaken. Corporate earnings may disappoint.
Sometimes those concerns will prove correct. Other times, markets will continue rising despite them.
Trying to determine exactly when the next bear market will begin and end is extremely difficult. Even professional investors cannot consistently identify market turning points in advance.
There's an old saying that more money has been lost by investors trying to anticipate timing of downturns than has been lost in downturns themselves.
Instead of asking yourself when the market might fall, ask "if the market falls substantially, is my financial plan prepared to handle it?". That change in perspective is important because while you can't control the market, you can control your preparation.
1. How Much Risk Should I Be Taking?
One of the best ways to prepare for a downturn is to determine your appetite and tolerance for investment risk. Your portfolio should reflect your financial goals, time horizon, liquidity needs, and ability and willingness to tolerate volatility or losses.
Asset allocation is inherently personal. An allocation appropriate for a 35-year-old accumulating wealth may be very different from one appropriate for someone who expects to retire soon or begin drawing income from a portfolio within the next few years.
One question I ask when onboarding and building a relationship with a new client is:
“How much of your portfolio could you reasonably tolerate losing without changing your long-term investment strategy?”
If the answer is substantially less than the potential volatility your current portfolio is exposed to, then you may be taking more risk than is in your best interest. That doesn’t necessarily mean you should dramatically reduce your stock market exposure. Yet, it may mean that your portfolio needs to be better aligned with your actual circumstances.
The goal isn’t to eliminate investment risk. Rather, it's to take an appropriate amount of risk in order to maximize your probability of achieving your long-term financial goals and objectives.
2. Build a Liquidity Reserve Before You Need It
One of the biggest mistakes I see investors make during a downturn is being forced to sell long-term investments to fund short-term expenses.
For example, if I have a client that knows they will need $100,000 from their portfolio over the next year, then the availability of that money shouldn’t depend on what the stock market does over the next several months. In this case, I would advise that client to set the $100,000 aside in low-risk short-term bonds, or a portfolio more heavily weighted towards short-term bonds than risks assets, like stocks.
Maintaining an appropriate amount of cash or high-quality short-term investments can provide an important buffer between your spending needs and your long-term portfolio. This is particularly important for:
Retirees taking portfolio withdrawals
Individuals approaching retirement
Business owners with unpredictable cash flow
Families anticipating large expenditures
Investors with concentrated stock positions
Anyone who may need liquidity during an economic slowdown
The appropriate size for a liquidity reserve varies from person to person. The objective is not to hold excessive cash indefinitely. Rather, it is to ensure that your near-term financial needs aren’t dependent on short-term stock market performance.
3. Diversify While the Market is Strong
A market downturn is a particularly unpleasant time to discover that your portfolio wasn’t actually diversified. Think of it like skinny dipping, and then all of the sudden the tide goes out.
Diversification doesn’t prevent losses, as even diversified portfolios can still decline substantially when markets fall broadly. However, diversification reduces the impact of any single company, sector, asset class, or economic outcome on your overall wealth. Consider whether your portfolio has meaningful exposure to:
A single company
Your employer’s stock
One industry or sector
One geographic market
A particular investment factor
Illiquid investments
Real estate
A single source of investment income
This becomes particularly important for successful professionals and business owners. You may already have substantial economic exposure to one company through your salary, equity compensation, or business ownership. Holding a large additional position in that same company through your investment portfolio can create a level of concentration that isn’t immediately obvious.
At RISE, we evaluate our client's portfolios in the context of their entire financial life, not simply just the securities held their brokerage account.
4. Don’t Confuse Volatility With Permanent Loss
Generally, I view risk as the potential for permanent loss of capital. It is important not to confuse this with volatility, or a decline in the market or value of an investment. Volatility usually only turns into risk if the investment is sold at a loss.
Markets fluctuate because investors constantly reassess the value of businesses, interest rates, economic growth, inflation, and countless other factors. While individual companies can of course experience permanent declines, volatile swings in the value of an individual company are often-times temporary.
Poorly structured portfolios can result in lasting damage, excessive leverage can magnify losses, and concentrated positions can become particularly dangerous.
5. Establish a Disciplined Rebalancing Plan
A market decline can create an uncomfortable, but potentially valuable, opportunity to rebalance. Imagine an investor begins with a portfolio consisting of 80% stocks and 20% bonds. If stocks experienced a 30% decline, the portfolio would then consist of 74% stocks and 26% bonds. Without rebalancing, that portfolio may have become too conservative for the investor to achieve their long-term goals.
Whereas, rebalancing after a decline in the stock market can restore the portfolio to its intended risk level.
In practice, this can mean selling assets that have held up better and directing the proceeds towards assets that have declined.
Psychologically, this can be difficult for some investors to wrap their head around. It requires the investor to buy the risk assets when headlines are negative and confidence is low. That is precisely why have a disciplined and rule-based rebalancing plan can be valuable.
Instead of asking yourself “should I buy stocks right now?”, ask “has my portfolio moved far enough away from my target allocation that my investment policy calls for rebalancing?”. That transforms an emotional decision into a portfolio-management decision.
6. Consider the Tax Opportunities Created by a Downturn
Rather than creating a tax disaster, market declines can create tax saving opportunities. For investors with taxable accounts, declining securities can sometimes create opportunities to harvest investment losses.
Tax-loss harvesting involves selling an investment that has declined below its tax basis and realizing the loss for tax purposes, potentially allowing the investor to offset taxable capital gains from elsewhere in their portfolio later on. The proceeds from tax-loss harvesting can then be reinvested into another appropriate investment while maintaining the portfolio’s overall investment exposure.
However, tax-loss harvesting shouldn’t be pursued simply because an investment has declined. The new, or replacement, investment still needs to fit the portfolio and financial plan, and investors need to consider tax rules governing repurchases and substantially identical securities.
7. Revisit Your Concentrated Stock Positions
Market downturns can expose concentration risk very quickly. Suppose an investor owns a large position in a single stock that has appreciated dramatically over several years. Selling the position to lock in the gains amid a downturn would create a substantial capital-gains tax liability. So most commonly, the investor's natural intuition is to continuing holding the position.
Then the stock falls 40%.
The investor may suddenly discover that the tax cost they were trying to avoid is much smaller than the potential cost of remaining concentrated. This doesn’t mean every concentrated position should immediately be sold though.
There may be legitimate reasons to retain a position, long-term conviction, charitable objectives, or estate-planning considerations. However, concentrated wealth should be addressed before a downturn, not after one. For investors with significant employer stock, business ownership, or other concentrated positions, diversification may need to occur gradually and strategically.
8. Retirees Need a Different Plan
A market decline can be particularly stressful for someone who is already withdrawing money from their portfolio. For most retirees, the problem isn’t simply that the portfolio has declined, but that they now need to sell investments at a lower value to fund their living expenses.
This scenario is referred to as sequence of returns risk. When you withdraw money from a falling portfolio, you must sell more shares or units to get the same cash amount than you would have if the portfolio had not fallen in value. Selling assets during a downturn locks in those losses, leaving less money behind to grow when the market eventually rebounds.
This increases the chances of outliving your retirement portfolio and makes liquidity planning particularly important during the transition into retirement. A retirement portfolio should therefore be evaluated based on more than its expected long-term return. When designing a retirement portfolio, investors should also consider:
Expected retirement spending
Social Security and/or pension income
Required minimum distributions from IRAs
Asset location (i.e. taxable versus tax-deferred assets)
Cash reserves
Withdrawal strategy
Longevity
Estate objectives
The closer you are to needing your portfolio for retirement income, the more important it becomes to understand how a significant market decline could interact with your cash-flow needs.
9. Create a “Bear Market Checklist”
One of the simplest ways to prepare emotionally is to decide in advance what you will, and will not, do during a major decline. Working with a financial advisor can be particular valuable with this, as part of an advisor's job is to help their clients stay disciplined and avoid the urge to make irreversible mistakes, such as panic selling when the market is down.
For example, "when markets decline, I will do the following":
Review my financial plan
Check whether my asset allocation has drifted
Rebalance according to my predetermined strategy
Review tax-loss harvesting opportunities
Reassess concentrated positions
Confirm that my liquidity reserves remain adequate
Look for opportunities to invest excess cash
Revisit my long-term financial goals
"When markets decline, I will not":
Make major allocation changes solely because of headlines
Sell everything and move to cash without a plan
Assume that the latest economic forecast is certain
Make decisions based solely on short-term market movements
Abandon a long-term strategy without reassessing the underlying financial objectives
This type of “bear market checklist” can be surprisingly powerful. It gives you an objective process to follow when emotions are strongest.
10. Don’t Try to Predict the Bottom
One of the biggest challenges during a market downturn is knowing when the decline is over. Unfortunately, the market doesn’t ring a bell at the bottom. Investors who sell after a substantial decline often face a second decision of when to get back into the market.
That decision can be even more difficult. Markets tend to recover before economic headlines improve. Additionally, it's typical for the strongest market days to occur immediately following days of large declines when uncertainty is running high.
This doesn’t mean investors should blindly “stay the course” regardless of circumstances, yet there is an important distinction between changing a portfolio because your financial circumstances or objectives have changed, and changing a portfolio because you’re afraid of what the market might do next.
The latter is a classic example of trying to time the market. If you ever have the urge to panic sell or time the market, just remember there is a cost to timing the market and that missing the 10 best days in the market over a given period has proved costly for long-term returns.
The Best Time to Prepare for a Downturn Is Before It Happens
You don’t need to know whether the next market decline will happen next month, next year, or several years from now. You need to know that your financial plan can withstand one.
That means understanding how much investment risk is too much to take, maintaining appropriate liquidity, diversifying your portfolio, addressing concentrated positions, establishing rebalancing guidelines, considering tax opportunities, and making sure your investment strategy is aligned with your financial goals.
Most importantly, preparation should happen when markets are calm. It is much easier to make rational decisions about risk when your portfolio is rising than when you are watching a six-figure or seven-figure account decline every day.
The objective isn’t to build a portfolio that never falls. It’s to build a financial plan that can withstand the fall.
At RISE Investments, we believe your investment portfolio should serve your financial plan. Not the other way around. We help clients integrate investment management with financial planning, tax considerations, retirement planning, and long-term wealth objectives so they can make informed decisions through both rising and declining markets.
Disclosure
RISE Investment Management, LLC ("RISE" or "RISE Investments") is an investment adviser registered under the Investment Advisers Act of 1940. Registration of an investment adviser does not imply any level of skill or training. This publication is solely for informational purposes and past performance is not indicative of future results. Any description of products, services, and performance results of RISE contained in this publication are not an offering or a solicitation of any kind. No advice may be rendered by RISE Investments unless a client service agreement is in place. Advisory services are only offered to clients or prospective clients where RISE Investments and its representatives are properly licensed or exempt from licensure. All of the information in this publication is believed to be accurate and correct as the date set forth. RISE does not have or accept responsibility or an obligation to update such information. Please note, this article is for education purposes and should not be treated as tax or legal advice. This article is not a substitute for legal or tax advice from your professional legal or tax advisor.