How to Protect Your Portfolio from a Stock Market Correction

Rising stock prices always create a bit of a mixed reaction. Yes, we like to see our money growing, but as prices reach new highs, concerns mount that the prices we’re paying for stocks are getting more expensive and that a correction may be on the horizon.
That’s the perspective of some investors today, as key stock indexes perch on several years of strong gains. The Dow Jones Industrial Average has risen more than 67% in the past five years. Although there are many signs that the economy is growing and corporate profits are rising, it’s natural to wonder how much room stocks have left to grow.
What’s an investor to do? Here are some things that sensible, rational investors might consider if they’re leery of being caught in a stock market correction but still believe in the long-term potential of the market.

1. Take (some) profits. Short of making the rash – and almost always unwise – move to liquidate your whole portfolio, times of high stock prices tend to be good times to, well, take stock. Have any of your holdings already doubled in value, or appreciated significantly? Stocks with a strong track record are often the very stocks you want to hold long term. But if you are comfortable with the amount some holdings have grown, selling them can also be a good way to convert some of your investments to cash, without losing a thing. Cashing in on these good investments may also be a good way to help you sleep better at night.
2. Stop reinvesting dividends. We spend a lot of time on this site discussing the value of dividend stocks, and for good reason. The good dividend stocks will pay you two ways: by appreciating in value and paying a cash dividend. While it’s common practice to reinvest dividends and gradually grow your holdings, keeping dividends in cash is a good strategy for gradually reducing your exposure to the market. It’s also a simple step that can be easily reversed if you have a change of heart.
3. Drip out. Are you enrolled in a drip fund or another mechanism that enables you to gradually purchase stocks? If you’re worried that prices have peaked and may be headed for a correction, consider gradually reducing the amount you are contributing. The effect of this move will be something like the move to stop reinvesting dividends, because it adjusts your holdings gradually. This is important because even if you’re convinced a correction is coming, it’s nearly impossible to know whether prices will correct in two months or two years.
4. Invest in bond funds. As an alternative to stocks (which are investments in equity), bonds – which are typically invested in corporate or government debt – can offer secure, if limited returns. Bond funds can provide a quick entrée into bonds for investors who are not familiar with the space. Like stock mutual funds, bond funds leave the investing strategy to the experts. If you’re looking for a simple way to expand your portfolio, but don’t feel sufficiently educated in the bond market to invest directly, consider bond funds.
5. Consider “radical diversification.” Most of us know about countercyclical investments that tend to do well when the economy’s failing, but often we don’t adequately diversify. In an increasingly connected world, more of the world’s advanced economies move in tandem. If your idea of investing in emerging markets is buying companies in the BRIC (Brazil, Russia, India, China) countries, for example, you may be holding some strong investments. But you might not be adequately buying into really young companies in places like Sub-Saharan Africa and Latin America, which not only have strong growth prospects but are less connected to the economic trends driving the developed world. Likewise, take a closer look at some obscure small cap stocks where you might find a diamond in the rough. Look beyond the usual suspects.
6. Run the numbers. Finally, do your own research and study up on stock valuations. Too often, investors seek out “recession proof” investments in stocks of companies making basic consumer goods that are always in demand. These companies may indeed be good investments. But “recession proof” is not “correction proof.” If you’re concerned about the investments in your portfolio, study up on the value of these stocks – the price relative to earnings and earnings potential – to get a sense for whether they may be overvalued.

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