How should investors respond to the possibility of a major drop in the US stock market?

Robust profits and the overall downward trend in inflation have propelled the S&P 500 index to soar, and almost no one wants to miss out. However, the S&P 500 index's 30% gain in the past 52 weeks mostly comes from a few stocks such as Nvidia (NVDA.US). The return of the Fear of Missing Out (FOMO) has intensified investors' concerns about the possibility of a crash in the US stock market. Some market observers worry that the market may experience a melt-up. This is a market phenomenon where sharp increases occur when investors flock to the market to avoid missing out on the opportunity for stock market gains. This phenomenon is usually not driven by improvements in economic fundamentals, but based on herd behavior and market optimism, leading to an increase in bullish sentiment in the market. In this scenario, the market may experience a period of accelerated strong gains, but may subsequently face heavy selling, leading to a market crash. Therefore, some seasoned market professionals and financial advisors have provided some advice, trying to help investors navigate through turbulent markets and create a portfolio that can withstand adversity. They suggest that investors should plan ahead for any market downturn to ensure that their portfolios are not affected. 1. Markets Tend to Recover Quickly To properly view market downturns, CFRA Research's Chief Investment Strategist Sam Stovall advises to consider stock market history as a "virtual sedative." He said, "I am surprised to hear from people that the average bounce back from correction or drop of 10% to 20% is measured in years. Most would say it's years, but the average is closer to about four months." Sam Stovall states that the speed of market rebounds proves that investors should not try to time the market, as timing the market requires accurately judging when to exit and re-enter. He adds that people often convince themselves not to re-enter the market, fearing that the bull market may be just another prelude to another decline, but missing out on the best days in the stock market performance could have a significant impact on long-term returns. 2. Downturns are Normal Just as it is normal for a well-functioning stock market to continuously hit new highs, it is also normal for the stock market to underperform. Rob Williams, Managing Director of Juxin Wealth Financial Planning, says, "To be a disciplined investor, you must accept the fact that even in a good market, the uptrend will not continue indefinitely, and the market will indeed decline." "The good news is that the stock market typically recovers, and the overall trend continues to rise." An analysis by Juxin Wealth Financial Planning on the annual performance of the US stock market between 2002 and 2021 reveals that in these 20 years, the market saw 10 years of declines of 10% or more, with an average pullback of 15%. This may sound stressful, but the good news is that for most of those years, the stock market trended upward. 3. Diversification While the S&P 500 index is important, most people do not invest all their funds in this index or the large tech stocks that have been driving its strong performance. Laura Mattia, Founder of Atlas Fiduciary Financial, says, "We continue to educate and remind clients that they should not only invest in the S&P 500 index and large tech stocks, as these stocks have high volatility, emotional trading, and inherent risks, as evidenced by the decline of these stocks in 2022." "While US large-cap stocks may make up a portion of our clients' investments, their overall portfolios are well-balanced across various asset classes, without over-inflating." Whether hiring a financial advisor or investing in the stock market through Target Date Funds (TDF), investors' holdings may be more diversified than imagined. For example, as of the end of 2023, the Fidelity Freedom 2030 Target Date Fund had a stock investment proportion of around 56%, with its stock exposure distributed across indexes of different regions and styles, including growth stocks, value stocks, large-cap stocks, and small-cap stocks. 4. Rebalancing to Reduce Risk If investors or their financial advisors have set an asset allocation for their portfolios, such as the classic 60/40 portfolio, as the market rises, their portfolio may become imbalanced. Selling appreciated stocks in taxable accounts does mean paying capital gains taxes the following year, but this can lock in gains and reduce the risk of the investment portfolio. Rob Williams, Managing Director of Juxin Wealth Financial Planning, suggests rebalancing the portfolio annually, but also adds, "If you rebalance more frequently, you may overreact to market trends." 5. Establishing a Buffer Many financial planners put their clients' money into different "baskets" for different goals and timeframes. A portion of funds reserved for short-term needs will be conservatively invested. George Gagliardi of Coromandel Wealth Management says that for those nearing retirement and needing to access savings to maintain expenses, this portion of funds may be invested in low volatility bonds with durations of one to three years, such as US Treasury bonds or high-quality short-term bonds. If investors have a medium-term deposit that may be used to pay for their children's college fees, as well as a longer-term deposit for retirement, allocating a significant amount of these funds to the stock market can provide investors with higher long-term growth and beat inflation. With short-term funds available to meet immediate needs, investors do not need to tap into those long-term funds, to avoid selling stocks during market downturns.