What investors can learn from the stock market 'correction'

There's a lot to learn from a stock market free fall.

Investors with 401(k)s looking to better prepare themselves for the next big dive should start by analyzing how their nerves and portfolios held up during this month's bout of turbulence, which briefly pushed down stocks 10% for the first time in two years.

The recent market "correction" in which the Dow Jones industrial average suffered two daily drops of more than 1,000 points likely exposed flaws in your financial plan and the way you think about investing.

With the market stable for now and the Dow having recouped about half of its recent losses despite Tuesday's 255-point slide, it's time to plan for the next scary plunge.

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"People should take this as a reminder of how markets behave," says Brad Bernstein, senior vice president of wealth management at UBS Financial in Philadelphia, referring to the 10% drop that stung investors during nine worrisome days. "They have been spoiled by a long period of low volatility and no market corrections."

The Dow has risen six straight sessions and is up 2% this year after Friday's 19-point gain to 25,219. 

Yes, volatility is back. But that doesn't mean you should cower in fear. Individual investors need to view the recent correction as a dress rehearsal of sorts for a potentially bigger market swoon, such as a bear market drop of 20% or more.

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Here's a must-do guide to prepare for the next period of tumult:

1. ANALYZE YOUR OWN BEHAVIOR

Successful investing is a lot about emotions. Doing a self-analysis, or examining how you dealt with the market downturn emotionally and psychologically, is a useful exercise. The reason: it will reveal how your brain processes risk.

First off, panic and fear are the enemies of good financial choices. The key is to remain calm and avoid a freak-out that results in poor decisions, such as bailing out on stocks just before the market rebounds. 

"Taking a moment to analyze your own reactions as an investor is a great idea," says Andrea Coombes, investing and retirement specialist at NerdWallet.com. "The real test is: 'Did you sell out of fear?'" 

If you did panic and dump shares, it's a sign that stocks may be too risky for you and that you need to trim your holdings and bulk up on lower-risk investments, like bonds and cash, Coombes says.

2. KEEP A FINANCIAL DIARY

To avoid making rash decisions, keep a financial diary, or "investing journal," that details your portfolio changes and the logic behind them, advises Dan Egan, director of behavioral finance and investing at Betterment, an online and digital financial advisory firm. 

"Go back and revisit your trades and see what you were thinking about at the time," says Egan.

This strategy will provide clues as to what triggers portfolio moves. It also creates a paper trail, which will help you identify behavioral patterns that may be hurting, not helping, your finances.

Egan also advises jotting down trades you're thinking about in your diary before you execute them, as it will let you know in real time whether you're making a change for the right reason.

3. FOCUS ON FACTS 

To squash fears, Bernstein of UBS focuses on market performance in past downturns. "I am a big fan of facts and data," he says. "It's a great time to remind clients about market history. And that corrections are normal."

During the recent slide he stressed to clients that 10% drops are normal and typically occur about once a year. He pointed out that while the Dow's 1,175-point plunge on Feb. 5 was the biggest ever, the percentage loss was only 4.6%, far below the record 22.6% one-day dive on Black Monday in October 1987. He also noted that since 1980 the market has finished higher 32 of 38 years.

4. PUT LOSSES IN CONTEXT

Just because stocks fall doesn't mean your portfolio is down that much, Bernstein notes. If you have only 50% of your money in stocks and the other half in bonds and cash, your portfolio's loss is about half of the stock market's loss.

Another way to keep losses in perspective is to look at them at different time points. Let's say an investor had $100,000 in the Dow at the start of 2018. At the market low on Feb. 5, the blue-chip stock index was down 8.5% from its peak, but only off 3.5% from the end of 2017. So even at the low this year, that account balance fell by only $3,500 to $96,500. The Dow has since climbed back into positive territory for the year.

5. STRESS TEST YOUR PORTFOLIO

So how would you cope with a big market downturn? The only way to know is to calculate how much money your current holdings could lose if, say, a bear market happened. That 20% market fall would mean a paper loss of $20,000 on a portfolio of stocks valued at $100,000. A bigger fall, like the 56% drop in the 2007-09 bear market, would slash the value of your portfolio by more than half.

"It's smart for investors to do a stress test on their accounts," says Jim Keenehan, senior consultant for retirement plans at AFS 401(k) Retirement Services.

Bottom line: Don't open yourself up to more financial pain than you can handle. 

6. MAP OUT A BATTLE PLAN

Put in writing now how you will respond to the next market downturn and stick to the plan, says Egan of Betterment. 

"Make the decision when you are cold and rational because you don't want to make financial decisions that are driven by emotions," he says.

For example, if you want to buy on a 10% dip, follow through when the next correction strikes. If you still plan on being a buyer with the market down 20%, refer to that written plan when the next bear market happens. 

7. TUNE OUT PUNDITS

Watching cable business news 24/7 is probably not in your best financial interest, as the media focuses on negative market events with greater intensity than bullish ones, says Keenehan.

"To avoid getting spooked, turn off the TV, and shut out the noise from the media" he says. 

8. STICK TO THE LONG-TERM PLAN

It's better to avoid making portfolio decisions based on a day, a week or even a month's worth of stock market action. The short term is a blip on the market's long-term journey.

"Trying to guess when the next bear market will hit is impossible," says NerdWallet's Coombes. "The best thing investors can do is make sure their mix of stocks, bonds and cash fits their long-term goals and their appetite for risk."

One more thing. A big drop has one undeniable benefit: "It lets you buy investments on sale," says Coombes.