How investors can prepare for the pain of a market pullback

  • During the dot-com bubble burst and 2008 financial crisis, markets dropped by about 45 percent.
  • Having stocks in your portfolio could provide great long-term growth, but too much could wreak havoc on your golden years — especially if you're nearing retirement age.
  • Have a frank discussion with a financial advisor about how to rebalance and diversify your portfolio so that it is still making you money but exposing you to less risk.

Making right moves now will help with the pain portfolios endure when downturns strike.
atakan | Getty Images
Making right moves now will help with the pain portfolios endure when downturns strike.

As as investor, if you're feeling calm about this long bull market, don't let the lack of volatility lull you to sleep. The risks of a pullback are still there.

Do you actually know how your portfolio would react in another downturn?

When was the last time you took a look at your retirement investments and subjected them to a stress test? We are now multiple years into what feels like the longest bull market ever. However, anyone taking a peek at the past knows that "what goes up must come down." And in the case of this current ride, it's not a question of how, but when the market will correct itself and turn bearish. The lack of volatility continues, but for how long?

Over the past two decades, we have seen two major market downturns, courtesy of the dot-com bubble and the financial crisis. During each of these incidents, the stock market fell at least 45 percent, meaning investors with a high concentration of their eggs in the wrong basket watched as their robust investments were sliced and diced.

Obviously, there is no such thing as a crystal ball. As advisors, we can't predict how long a winning streak will continue or when a market downturn will occur. But we can always counsel clients on how to take proactive steps.

Making the right moves now will help alleviate some of the pain your portfolio could endure when the next downturn strikes.

For example, are you overweight in stocks? One look at your most recent statement and you'll probably note that these types of investments have most likely kept pace with the market. And who doesn't love that? But if you are heavily invested in stocks, exposure to downturn risk goes hand-in-hand with the sky-high market. If you are nearing or in retirement, the goal is to slow your risk exposure down before it's too late. Having stocks in your portfolio could provide great long-term growth, but too much could wreck your retirement.

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The best way to thwart future pain is to check in on your portfolio annually and put it through a few paces. A savvy financial advisory firm will use software that allows clients to run a stress test and see what their portfolios might do if the market tumbled 20, 30 or 40 percent. Clients are able to pinpoint what may do well, what could falter and what steps, if any, they should take to mitigate risk.

In order to conduct your own stress test, you will want to know what portion of your portfolio is allocated to which investment vehicle and how this directly exposes you to risk. You will want to know how your investments would perform during a market downturn, paying specific attention to what would perform well and what wouldn't.

It is also a good time to consider a downturn's impact: What would be left in your retirement savings, and what would that mean for your daily living? The reality is that as you close in on retirement, you are going to start tapping into it. It is not ideal to have large risk in your portfolio at that point.

Speaking of risk, if the term has you cringing in your seat, you're not alone.

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However, that doesn't mean you should bury your head in the sand and pretend it doesn't exist. Every investment vehicle comes with its various strengths and exposure to risk. But the secret to tackling this is to remember that risk itself isn't necessarily bad.

Once you've conducted your stress test and know where the chips may fall, it will still make sense to continue to have a portion of your portfolio allocated for long-term growth (aka, money you're not going to need in the next five years). But you don't want the money you might be spending in the next few years tied to any sort of volatile asset.

When you know what your allocation is, have a frank discussion with your advisor about the best way to rebalance and diversify your portfolio so that it is still making you money but exposing you to less risk. I get it: It's no secret that you won't get rich by diversifying your portfolio.

But as a preventive measure, diversification is a great way to protect your wealth. If you're nearing retirement, take a serious look at your investments to see how much is tied to stock. If it's more than 70 percent or 80 percent, you really need to take a good look at how much risk you want to have going into retirement.

Once you've gotten into the habit of running a check-up on your portfolio each year with your advisor, it will be easier to rest assured that you've done your due diligence. This will help to ensure your future is protected and safe no matter what the market does.

— By Scott Hanson, co-founder and senior partner at Hanson McClain Advisors

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