Work-Free Wealth

Income Investing for Financial Independence and Early Retirement

What to do when the stock market goes crazy

The Dow had the largest point drop in history so far yesterday (Feb 5) but it was far from the largest percentage drop.  Suddenly, the news are filled with doom and gloom predictions.  It makes me wonder if artificial intelligence has taken over news postings depending on the current sentiment.  Will we have a correction (a drop of at least 10%) or maybe even a bear market (a loss of more than 20%).  I don’t claim to know and it may not really matter.   The stock market has never been a smooth ride straight up.  If you are still accumulating and investing every month, a drop is a good thing.  You get to buy more shares for your money.

For Retirees and anybody enjoying the Financial Independence life:

Once you are in the withdrawal stage, it is a different game.  Selling shares in a down market is terrible for your long-term returns.  That is why I advocate living of your portfolio income.   Dividend stocks don’t cut their distributions just because the stock market corrects.  They may cut distributions in a serious recession.  The S&P 500 dividend cuts amounted to about 22% during the financial crisis in 2009. Obviously, a 22% drop in income is bad news but not nearly as bad as having to sell shares that dropped 50% in value.  If you have some uncorrelated assets in your portfolio, the overall portfolio income drop is likely less.  Lately, it seems that most assets move together.  Stocks and bonds are both down.  Interestingly, in my own portfolio, I noticed that my high-risk investment allocation has actually done better than my dividend index fund.  My mortgage REITs did better than the more conservative equity REITs likely due to their portfolio being floating rate and the economy still humming along.  However, nobody knows in advance.  Even if you get to predict the top, can you predict when it’s time to get back in?  Well, neither do I.

Be prepared at all times

So what to do when the stock market drops?  It is simple but not easy: just wait it out.  You need to be prepared ahead of time since things can happen fast.    Preparation includes:

  • Create a diversified portfolio. It might seem that right now everything drops or rises together so you could be thinking that diversification does not matter anymore.  That can change fast.  Over long investment horizons, REITS and the overall stock market only have about 30% correlation.  Long-term Treasuries and stocks are typically negatively correlated, i.e., if stocks go down, bonds go up.
  • Keep cash for dividend cuts during a bear market. I suggest about 70% of your income needs in cash. This amounts to about twice the 2009 dividend cut (40%) plus an extra 30% for the following years until the dividend income reaches previous levels.  Some people need 2 to 3 years of living expenses as a cash cushion to feel safe.  If that is what you need to stay invested, go for it.  Much of stock market investing success hinges on being able to stay in the market and staying calm is during wild drops is key.    Obviously, cash is a drag on returns in the long run.  Cash always loses to inflation, so I am not going much higher than 1 year’s living expenses and are dropping below that level quite often.
  • Keep the stock market history in mind. In the long run, stocks go up.  Black Monday was bad when it happened but it looks like a minor blip in retrospect.  Take a look at the Dow Jones history until today.  Do you see yesterday’s drastic drop?  Me neither.

If you are still in the accumulation phase, keep investing and enjoy the gains that will eventually follow.

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