This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
The Nasdaq Composite exploded higher by 9% over just five recent trading days, pulling the index out of its brief stint in a bear market. The index remains in correction territory, but the rebound is a big reprieve. But we aren't out of the woods yet.
No one knows if the market will retest its 2022 lows. What we do know is that volatility remains high, and the month of March has been chock-full of broad market gyrations with several big days to the upside and the downside.
Given all the uncertainty, it's better to prepare for further downside now than be complacent and get caught off guard. Here are five questions you should ask yourself in case the stock market keeps crashing.
1. Why are you investing?
The stock market is but one playing field upon which several different games are simultaneously being played. Some folks are day trading and care nothing about fundamentals. Instead, their focus is on short-term price action and technical analysis. Others are trying to bet big on a moon shot. Some people are trying to beat the market over a multi-decade time horizon. And many folks are simply focused on capital preservation or passive income generation in retirement. There's a big difference between a Wall Street hedge fund with billions of dollars under management and an 18-year-old kid with $500 in spare cash they made over the summer.
Once you begin to understand the different types of investors and their different motivations, it becomes easier to understand why stock prices can do crazy things. Put a different way, knee-jerk reactions and market volatility become less surprising.
Although it can be tempting to try to time the market, the best an investor can do is be roughly right, pick good companies, keep a level head, and let the power of patience and compounding returns do their work over time. These are tools that are free to use, yet many investors ignore them in favor of gambling.
2. What is your time horizon?
Your investment horizon is heavily influenced by age. But it can also depend on different financial obligations or upcoming expenses. Some investors are in the asset accumulation phase, while others are in the asset distribution phase.
Younger investors who still have their highest-earning years ahead of them and fewer financial obligations can afford to take risks and can use decades of portfolio growth to their advantage. Investors nearing retirement, or any period where spending may begin to outpace income, tend to be more focused on safeguarding their nest egg and protecting against downside risk. In this sense, an investor with a longer time horizon can afford to have a higher percentage of their assets in growth stocks while a retiree may be more interested in the income from stable dividend payers.
3. What is your risk tolerance?
Looking at a chart of stocks that beat the market over the last few decades is a simple enough exercise. But not all gains are created equal. In fact, some of the best stocks have been extremely volatile and required nerves of steel to hold during certain time periods. For example, Amazon (NASDAQ: AMZN) stock lost nearly 90% of its value in less than 18 months during the dot-com bubble burst in the early 2000s.
Between 23 October 2007 and 20 November 2008, Amazon again lost 65% of its value. And then between 4 September 2018 and Christmas Eve 2018, Amazon lost over a third of its value. However, even if you bought Amazon stock at its peak right before the dot-com bust on 3 January 2000 and suffered through those declines, you would be sitting on a 3,500% gain as of this writing.
The lesson here is to understand your temperament and risk tolerance before buying a stock. Investors who bought Amazon and panic sold missed out on some major gains. But the decision is all too clear in hindsight and never easy in the moment.
4. How vulnerable are you to volatility?
Exposure to volatility combines your personal investment objectives, time horizon, and risk tolerance. For example, a young investor who hates risk but is investing for the next few decades may find themselves with a higher equities allocation than a risk-tolerant investor who has some major purchases coming up or is nearing retirement.
Understanding you and your family's exposure to volatility is a good exercise that can help build a portfolio that is best for you. Often, being vulnerable to volatility means taking fewer risks and allocating a higher percentage of your savings toward cash and bonds instead of stocks, even though stocks tend to outperform cash and bonds over the long term.
5. What kind of investor do you want to be?
Most of us have our favorite investor role models. Some gravitate toward the characters in Michael Lewis' The Big Short who correctly predicted the financial crisis and made money from it. Others appreciate Peter Lynch's grassroots style or Warren Buffett's patience and wry wisdom. Some folks want to be gunslingers and take bold bets. Others want to stick to what they know and invest in a way that helps them sleep well at night.
At The Motley Fool, we try to foster principles that will give you upside potential, encourage creativity, and provide you with an overall balanced approach. By doing your own research and keeping a diversified portfolio that blends long-term upside with proven winners, you can structure your investments in a way that suits your style.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
