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How You Can Prepare Yourself for a Market Correction

With many major share market indexes around the world slumping over the past week – the Straits Times Index (SGX: ^STI) in Singapore was relatively well-buffered with a weekly decline of just 1.0% – many investors are worried that the drop will continue and eventually form a major stock market correction (a correction’s defined as a fall of at least 10%).

News flashes on the biggest monthly drop in Germany’s industrial production since 2009 and stalling growth in China have added to investors’ woes too.

We won’t know whether shares will continue falling or if it will rebound. But with things as they are now, it seems wise to look at what we can do to prepare ourselves for any possible upcoming market correction.

Diversification

The legendary investor Sir John Templeton once mentioned some wise words on the importance of diversification:

“Diversification should be the corner stone of your investment program.  If you have your wealth in one company, unexpected troubles may cause a serious loss; but if you own the stocks of 12 companies in different industries, the one which turns out badly will probably be offset by some other which turns out better than expected.”

Thus, you can seek to minimise damage to your portfolio during a market correction by spreading your investments across different industry groups. Here’s a word of caution though: There can also be such a thing as over-diversification. According to another investing legend Warren Buffett, “wide diversification is only required when investors do not understand what they are doing”. In other words, if you know what you are doing and yet diversify too widely, you might not lose much, but you won’t gain much either.

So, take a look at your investments now and ask yourself the following important questions: Are all your share investments confined to only a particular industry? Have you invested in only a small handful of companies?

If you do, perhaps you should consider diversifying your investment holdings.

Sticking to your guns

Reminding yourself to stick with your investments even during tough times is another good way to handle a possible market correction.

If you’re a long-term investor, you can afford to ignore short-term price declines because history has shown how the markets can climb steadily upwards despite all the troubles and worries the world has faced.

It also pays to stick to your investments as opposed to jumping in and out of the market. According to a research study, a $10,000 portfolio that remained invested in the S&P 500 (an American market barometer) continuously for a decade starting from 30 January 2004 would have grown to $20,922 – an annualized return of 7.66%. However, when you miss only the 10 best days of the index, your annualised return drops to a paltry 1.31%!

Considering that the study covered 2,514 trading days and that just a miniscule fraction of trading days had such a major impact on the market’s returns, it makes sense to invest for the long-term to maximize your chances of being invested during the market’s best days.

Go for some bargains!

Lastly, it is wise to remind yourself to embrace a stock market correction like you would during a store-wide discount sale in your favourite stores.

Market corrections can be painful events due to temporary losses, but they also enable investors to snap up bargains. One good example is the 2011 correction that the STI suffered – Singapore’s market barometer had fallen by 19% from the start of the year till December. From its lowest point in that correction (which was reached in December), the STI has gained some 21% to its current level of around 3,200 points.

Some of the index’s components, like Southeast Asia’s largest bank DBS Group Holdings Ltd (SGX: D05), did even better with a 56% gain in the same time period.

Foolish Bottom-line

To sum up, the three things you can do to help prepare for a market correction are: 1) Diversify; 2) remind yourself to stick with your investments; and 3) steel yourself to embrace the bargains which can appear during a correction.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor James Yeo doesn’t own shares in any companies mentioned.