To prepare a portfolio for market downturns, choose an asset mix that fits your goal, time horizon and ability and willingness to tolerate losses; diversify both across asset categories and within them; then rebalance using a rule you set in advance. Diversification can help manage risk, but it cannot prevent losses or guarantee that investments will recover on a particular schedule.
Start with the goal and when you need the money
Before choosing investments, identify what the money is for and when you expect to use it. The U.S. Securities and Exchange Commission (SEC) says an appropriate asset mix depends substantially on an investor’s time horizon and risk tolerance. Risk tolerance includes both your willingness to accept market declines and your financial ability to withstand them.
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A goal that is close may leave less time to recover from a loss, so it may call for less investment risk than a long-term goal. Conversely, being too conservative for a distant goal can make it harder to meet long-term growth needs. These are planning principles, not a single allocation recommendation for every investor. The SEC’s Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing explains why time horizon and risk tolerance matter.
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Common categories include stocks, bonds and cash equivalents. They have different potential risks and returns, but none should be treated as a guaranteed shield against a downturn.
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- Stocks: The SEC characterizes stocks as having historically higher risk and higher potential return. Their prices can fall substantially, including over periods when an investor needs to sell.
- Bonds: Bonds are generally less volatile than stocks and have more modest returns, but they carry risks of their own. High-yield bonds, for example, carry higher risk than higher-quality bonds.
- Cash equivalents: These generally have low investment-loss risk, but inflation can erode the purchasing power of cash over time.
Asset categories may perform differently under different market conditions, which can help manage risk when combined. But relationships between investments can change, and all parts of a portfolio can lose value at once. The SEC’s guide notes that large-company stocks as a group have lost money on average about one out of every three years; the guide does not specify the observation period, so that figure is not a forecast or a measure of how often bear markets occur.
How do I diversify my portfolio?
Diversification has two layers: spreading investments across categories, then spreading exposure within each category. Within stocks, that means avoiding dependence on only a few companies or one industry. Within bonds, consider the range of issuers and exposures rather than assuming that several bond funds necessarily behave alike.
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Mutual funds and exchange-traded funds (ETFs) can make it easier to own portions of many investments, but the number of funds you own does not establish that your portfolio is diversified. Funds can hold many of the same large companies, or several can focus on the same sector. Review each fund’s underlying holdings and sector exposure to see what it actually adds. The SEC explains this distinction in its guidance on mutual funds and ETFs.
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How should I protect my investments in a market downturn?
Build a portfolio around a suitable mix and broad exposure rather than trying to predict when markets will fall. Diversification can improve the chances of limiting losses compared with concentrating investments in a few holdings, but it is risk management—not insurance. As the SEC’s Investor.gov page “Diversify Your Investments” puts it: “Diversification can’t guarantee that your investments won’t suffer if the market drops.”
A diversified portfolio can still decline when markets fall, and an allocation that is suitable for one investor may be wrong for another. Avoid assuming that bonds, cash or any particular fund will always rise when stocks fall. The practical aim is to avoid unnecessary concentration and choose a level of risk you can sustain through difficult markets.
Set a rebalancing rule before markets move
Rebalancing restores a portfolio toward its intended allocation when market movements cause some categories to grow faster or fall further than others. Decide in advance how you will review the mix, rather than changing it in reaction to headlines.
The SEC describes two broad approaches: review at intervals or act when allocations drift beyond preset percentage bands. Some experts use intervals such as six or twelve months, while others use thresholds; these are examples, not a universal schedule or recommendation. The SEC says rebalancing generally works best when relatively infrequent.
- Write down your target mix. Choose it based on your goal, time horizon and ability and willingness to tolerate losses.
- Choose a review method. Use periodic reviews or a preset drift threshold, and apply the rule consistently.
- Restore the mix if needed. You can trim categories that have grown overweight, add to underweight categories, or direct new contributions toward underweight holdings.
- Check the costs first. Selling can have tax consequences, and trades may incur transaction costs. Consider these before acting; a tax adviser or qualified financial professional may help with a complex situation.
When a target-date fund may make sense
A target-date (or lifecycle) fund pools investments and generally shifts toward a more conservative allocation as its target year approaches. The fund’s adviser manages the allocation and rebalancing, which can simplify upkeep for someone who prefers a packaged approach.
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The target year alone does not establish that a fund is right for you, and the fund does not guarantee against losses. Review its holdings, investment strategy, risks and costs, and consider whether its allocation fits the goal for which you are investing. The SEC discusses target-date funds in its Investor.gov guide to target-date funds.
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