Four steps investors can take to prepare for the next market downturn

With stocks hitting new record highs and the bull market nearly a decade old, it may seem like an odd time to think about the next downturn.

But as the old saying goes, hope for the best and prepare for the worst.

The S&P 500 is up more than 380 per cent, including reinvested dividends, since the depths of the financial crisis in March of 2009. The Dow Jones Industrial Average topped 27,000 recently. Despite some warnings of an economic slowdown ahead, investors are pushing stocks higher.

It's important not to get complacent, though. Since there is no easy way to predict with certainty the coming of a bear market, it's best to start thinking about the next one long before conditions start to deteriorate.

Part of this is about human nature. Like a bear market, it’s difficult to predict a market peak, and by the time it’s in the rear-view mirror, many investors succumb to panic and sell their holdings at the worst time. Then they tend to stay on the sidelines for too long, failing to recognize the beginning of a recovery.

This behaviour – and the tendency to use the most recent past as a prediction for what will happen in the future – can do serious damage to an investor’s ability to meet long-term goals.

That's why having a firm understanding about your process and strategy, and reviewing it before the chaos sets in, will go a long way to ensuring that you don't make the same mistake.

There are four steps investors can take to help prepare for the next downturn, even though markets are riding high right now.

1. The first is to understand their individual risk tolerances. This is going to be different for everyone depending on their level of conservatism and even their stage in life. But it’s easy to forget what your threshold for pain is when stocks keep rising and investors feel confident. Investors need to imagine what their reaction would be if the bottom suddenly dropped out – as it did in December of last year. Investors should ask themselves honestly how much they are willing to lose.
2. The second step investors can take is to set goals. This gives them something to focus on other than the daily market fluctuations. A long-term investment plan helps an investor put risk limits on the money invested for the short term while reaching for more yield on money invested that won’t be needed for many years.
3. A third step is to make sure to diversify. Holding a mix of stocks and bonds, and even different sectors and industries within the stock portion of the portfolio, means the investor is poised to ride out any market upheaval, and make money in both up and down stock markets.
4. The last thing investors can do is to remove the emotion from their investment decision-making. This is perhaps the hardest step, because it is human nature to react emotionally during times of stress. Scary headlines and dire predictions by talking TV heads feed into the panic during market declines. Investors need to remember that they have put together a process and strategy for a reason, and there’s no sense abandoning it when markets falter.

Investors who have stuck with the market through ups and downs in the past decade have benefited handsomely by the long-running bull, and there’s no reason to expect a bear market is right around the corner. But it’s worth preparing now for the inevitable time when the bear does arrive, and unprepared investors scatter to the wind.