Seven ways to handle a market correction

Now that we stand six years removed from the Financial Crisis that preceded the current bull market in stocks, let’s understand how to react when a “correction” eventually occurs. Financial markets are characterized by long cycles with many ups and downs. The successful investor blocks out fear and sensationalism and recognizes that these market cycles are part of investing. In practically every bull market of the last 40 years, the U.S. stock market has experienced a correction during its rise. Read on for 7 ways to deal with the next one.

In 2009, many investors were cashing out of the stock market. Things had been choppy for almost two years, and recent performance led them to behave as though the market was going to continue to go down. However, many of those who stayed invested saw stronger than average results over the next few years. In fact, since March 2009, the Standard & Poor’s 500 Composite Index is up more than 200%, making this the fourth-longest bull market in history. The year 2013 alone saw 45 new record highs in the S&P 500, so an upcoming correction in this current bull market may be due.

What should you do?

First, some background. A market correction is a decline of 10% or more in a stock, bond, index or mutual fund. Corrections can happen at any point in a market cycle, so selling your stock or bond funds during one may not be the best move.

Research shows, however, that emotional selling is all too common. This is bad because investor behavior and poor decision-making can adversely affect returns. A study released in 2014 showed that the average individual equity investor had a 20-year average annual total return that was 4.20% less than the index, directly related to poorly timed decision-making.*

Learn from other people’s mistakes and avoid emotional selling during the next correction with these 7 tips:

1)     Know your history

Since 1900, there have been 35 declines of 10% or more in the S&P 500. Of those 35 occurrences, the index fully recovered its value after an average of about 10 months. There have also been 15 declines of 20% or more, and the market has recovered its value after an average of about 20 months. With that perspective, if your investing time frame is years or even decades from now, it may be best to sit tight and stay invested. Of course, there’s no guarantee that the length of future recoveries will happen in a similar time, or at all. But unless you have a need for the money in the short term, consider just being patient.

2)     Be realistic

Since March 2009, the S&P 500 has more than doubled in value with an annualized return of more than 20% through December 31, 2013. The S&P 500’s average annual total return over the past 50 years is 10%. We’ve been in a recent period of outstanding results. With long-term historical returns of the S&P 500 as a precedent, keep in mind that the recent results are unsustainable; your expectations may have become unrealistic.

Over the last five years, some investors have seen their portfolios double in value. It is not prudent to assume that rate of growth can continue. Although there are no guarantees, an average annual return on an investment of 10% is in keeping with the long-tern historical trend. This pace is sufficient to help you achieve your financial goals. An investment doubles in slightly more than seven years at 10%.

3)     Look at market corrections as a buying opportunity

Historically, market downturns present us with some of the best opportunities to buy stocks, sukuk or mutual funds at a discounted price. If that new cell phone you had been wanting to buy were to go on sale at 10% or 20% off, you would probably consider making a move. If a stock or stock fund were to similarly go on sale, it may actually be an advantageous time to buy.

4)     Make sure you are properly allocated

Well before a market correction, you should revisit your portfolio to make sure it is aligned with your time horizon and financial goals.

By developing a balanced portfolio of investments, you make sure that not all your eggs are in one basket. This is known as asset allocation. A portfolio that mixes a variety of asset classes generally has a lower risk for a given level of return. Although it cannot guarantee a profit or protect against a possible loss, asset allocation, or diversification, can help spread the risk of investing because it broadens your investment base.

5)     Remember to rebalance

Having a mix of assets that works best for your situation is an important part of investing. Over time, however, market moves can affect the allocation of your assets. For example, because of outsized market performance since the end of the Great Recession, your portfolio may have become too exposed to stocks for your goals. Therefore, you might be taking on more risk than you realize and should consider taking some of your gains off the table and reallocating them to less volatile halal fixed income. That’s called rebalancing, and we can help you do that.

6)     Take the long view

When people are told to think about the long term, there’s usually some confusion. How long are we talking about? To get a better idea, ask yourself how long you have until retirement or whatever savings goal you might have. That’s a start. And then remember that market cycles are a normal part of investing.

If you’re looking at a retirement time frame of 20 years, it’s not unreasonable that you’ll experience two or three market cycles over that period. And those are full, long-term market cycles, not cyclical corrections in the market. So, it is ill-advised to use a short-term correction in the market as a reason to change how you are invested for a 20-year investment goal. Patience can be rewarded.

7)     Have a plan

Remember that investing is a process—not an event. You should not make rash moves in response to market cycles. Although you cannot control what happens in the stock market, you can control how you prepare and respond. Market ups and downs are part of investing. The important thing is to stay invested, remain patient and have a plan. Give an Azzad investment advisor a call at 888.86.AZZAD. We would be happy to discuss your risk tolerance, investment goals and time horizon.

*DALBAR, Quantitative Analysis of Investor Behavior, 2014. Dalbar.com

Past performance cannot guarantee future results. No investment strategy can eliminate the risk of losses. Asset Allocation, rebalancing and diversification are investment strategies used to help manage risk. They do not ensure a profit or protect against a loss.