Preparation

For the next time the market takes it on the chin.

The market has been on a tear since 2009, but there have been some rough patches along the way: the European Debt Crisis and U.S. credit downgrade in 2011, the oil price collapse in 2015-2016, and the Covid Crash in 2020. Each felt like a bloodbath at the time (The National Post even had a headline in all red that said “Markets Bleed”) but even including those few corrections, the market has been on a tear over the past fifteen years.

There will be another rough patch. We have no idea when it will happen - but it will happen. This post isn’t about predicting the next market correction. It’s about preparing for it.

As Morgan Housel, author of The Psychology of Money, put it: every past market crash looks like the opportunity of a lifetime; every current market crash feels like the end of the world.

To understand how painful a crash can feel, let’s go back to 2008 and the Great Financial Crisis. From peak to trough, the S&P 500 dropped 56.8%. Imagine your $1 million of life savings was fully invested in the S&P 500 (not ideal, because diversification matters). You just watched it drop by over $500,000. 

I don’t care how stoic you are, how much you know the market always recovers, or how committed you are to long-term investing. A drop like that hurts. And it hurts a lot.

In 2011, while working at a credit union in town, I met people who told me, “I was planning on retiring in 2009, but my investments dropped by xyz%, so I have to keep working.” Those were tough conversations for a 24-year-old. What was I supposed to say? “Why were you 100% in equities?” or “Why didn’t you set aside the income you’d need for a few years?” Thankfully, I kept my mouth shut. Hindsight bias is real, especially for a know-it-all 24-year old with little experience.

Those conversations shaped how I approach portfolio management for clients nearing retirement today. Protecting against short-term, and even medium-term, volatility is essential. And that’s what I want to discuss here: how to prepare for the next time the market takes it on the chin.

• If you’re near retirement (i.e., retiring within five years), set aside a war chest in your portfolio. 

It took four years for the market to recover from the crash in 2008. So, it took four years for that $1 million that turned into $500,000 to get back to $1 million. Four years. I am not suggesting in any way that the next market crash will be like 2008, but history is important. 

For most clients, I recommend a three-year war chest, but if you’re particularly risk-averse, extending it to five years is the appropriate course of action. Three to five years aligns with historical recovery times for most major corrections, so it should provide peace of mind during downturns. 

What is a war chest? Well, it’s boring. It’s high-interest savings, GICs, and/or short-term bonds. i.e., things that can’t or shouldn’t drop when the market drops.

Yes, you might miss out on some returns. But as we’ve seen, the security of knowing you’re covered during tough times often outweighs the potential gains.

• Once you’ve secured your short-term needs. You should consider how much risk you’re truly comfortable with.

I am not a fan of risk tolerance questionnaires, and I know most clients aren’t either. There’s a joke we have in the profession: in bull markets, clients’ risk tolerances are high; in bear markets, clients’ risk tolerances are low. But you can reassess your tolerance for risk without the questionnaire. Here are my three favourite ways to do this. 

First, translate percentage drops into dollar drops. A 20% drop might not sound bad, but if you have a $2 million dollar portfolio, that means a $400,000 drop. 

Second, if you’re retired or close to retirement, look at everything in terms of the amount of income you take or will take from your portfolio. A 15% drop could mean three years of income is no longer showing as available in your account. 

Third, what happens if you lose your job too? Be careful.

• Know what’s coming from TV, Youtube, the radio, and podcasts, and your friends, family, and network. 

TV, Youtube, the radio, and podcasts need viewers and listeners to survive. Pessimism is seductive (link here to a great Morgan Housel piece). They need you to keep tuning in. 

Your friends, family, and network don’t know any more about the future than you do. They will tell you they did X with their money, or their smart friends did Y with their money. Scared mobs are worse than greedy mobs. Don’t let fear make you do something stupid. 

• If you’re not close to retirement, just keep buying.*

If you’re still in accumulation mode, rejoice. You want to buy things when they are inexpensive. Market downturns are like a fire sale. Prices are lower. This is your chance to buy.

• Do not react. 

Market corrections are inevitable. They are the price of admission for entry into the market, and for the long-term returns that equities deliver. Being invested means having to endure tough times, so accept the price of admission for the effect of compounding wealth over time - even if it can be expensive sometimes.  

History shows that the biggest market gains often come right after major downturns. Reacting emotionally by selling at the bottom can mean missing those critical rebounds. After the S&P 500 bottomed out in March 2009, it recovered to new highs within four years. Those who sold during the downturn missed out on remarkable gains.

With preparation, perspective, and discipline, you can navigate the worst the market can throw at you successfully. What’s that old saying? A smooth sea never made a successful sailor? 

If you’re not sure if you’re prepared, give us a shout. 

*Though it’s more for an American audience, the book “Just Keep Buying” by Nick Magiulli is a fantastic read for younger investors.