After ending 2021 at nearly an all-time high, the S&P 500 experienced its worst month since March 2020 in January, as the index declined more than 5%. While we’ve seen some recovery since then, it’s good practice to take stock of your entire financial plan — as well as your emotional barometer — to see if you’re well-positioned to endure a potentially long period of lower stock market returns.
Here, we’ll review four lessons to be learned from last month’s stock market debacle.
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1. You need an emergency fund
While some people believe that the concept of an emergency fund is outdated, the reality is that in the midst of a stock market correction, you’ll almost certainly feel differently. Widely accepted financial planning advice dictates that you should maintain an emergency fund — that is, liquid cash reserves — that covers three to six months of living expenses, depending on your specific circumstances. While this isn’t necessarily the “return-maximizing” option, it serves other critical purposes.
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First, a fully funded emergency fund allows you to leave your stocks alone when they decline in value. Selling your stocks at their lows to fund immediate-term expenses is a recipe for stunting your portfolio’s long-term growth. Doing this should be a last-resort option.
Second, an emergency fund prevents you from trading on emotion. If you’re following the news when the market crashes, you’ll likely see nothing but panic sellers and flashing red numbers — enough to make anyone feel like they should act.
The reality is that an emergency fund acts as a buffer between your emotions and your actions and is likely going to make you feel much better about sticking to your long-term plan if stocks go south.
2. Bonds are not dead
While people are quick to cite paltry yields as a reason to stay away from bonds entirely, it’s important again to remember that bonds serve the purpose of reducing portfolio volatility, not necessarily maximizing investment return.
A portfolio that whipsaws back and forth, like one comprised entirely of common stocks, is likely to cause an investor to constantly question their decisions, potentially tempting unnecessary trading. A more balanced portfolio with a healthy bond allocation, on the other hand, has the potential to earn a very strong return without nearly as much embedded risk.
A recommitment to at least a 10% or 20% bond allocation is the ultimate display of humility: We don’t know what stock returns will be in …….