How to Prepare Your Portfolio for a Severe Market Fall

Severe stock market falls are uncomfortable to think about. That is precisely why investors should consider them before they happen.

During the global financial crisis, the S&P 500 fell 57% from its October 2007 peak to its March 2009 trough, according to the Federal Reserve's history of the Great Recession. The associated US recession ran from December 2007 to June 2009, based on the NBER's business-cycle dates.

The lesson is not that another crisis will follow the same pattern. It is that diversified equities can suffer deep losses and may require years to recover. A sensible portfolio should account for that possibility without relying on anyone's ability to predict when it will happen.

Start with when you need the money

The right level of risk depends less on your market outlook and more on your time horizon.

Money needed for next year's house deposit has a different job from money intended to fund retirement in 25 years. Combining both into one mental pot can lead to an unsuitable allocation.

A useful approach is to divide money into broad time-based buckets:

• Cash for emergencies and near-term spending
• High-quality, shorter-term bonds for intermediate needs
• Diversified equities for money that can remain invested for many years

The dividing lines will differ between investors. The important point is that essential spending should not depend on selling shares at a favourable price.

If a market fall could force you to sell investments to pay bills, the problem may not be the market. It may be a mismatch between the portfolio and the spending plan.

Cash is there to buy time

Cash often looks unattractive during a rising market because it usually offers lower expected long-term returns than equities. However, return is not its only purpose.

Cash provides liquidity. It can cover an emergency, a period without employment or a planned purchase without requiring shares to be sold after a large decline.

This makes cash a form of portfolio resilience rather than simply an investment competing with the stock market.

There is no universal percentage that every investor should hold. A better question is how many months or years of foreseeable spending should be protected from market volatility.

The answer depends on factors including income security, planned withdrawals and access to other resources. Investors should also check what protection arrangements apply to deposits held with their chosen provider.

Cash still has costs. Inflation can reduce its purchasing power, while holding too much for decades may limit long-term growth. Its role is to protect flexibility, not necessarily to maximise returns.

Bonds need a clearly defined job

Bonds can help reduce reliance on equities, but they should not be treated as risk-free.

Their prices can fall when interest rates rise. Longer-maturity bonds are generally more sensitive to changing rates, while lower-quality issuers bring greater credit risk.

That means an investor seeking stability should be careful about reaching for extra yield. A bond allocation designed as a defensive reserve may fail in its role if it contains too much duration or credit risk.

One practical principle is to match the character of the bonds to the likely spending horizon. Money that may be required relatively soon generally calls for greater emphasis on quality and shorter maturities.

My guide to buying bonds with more than three years to maturity explains why maturity matters when assessing interest-rate risk.

Bond funds also behave differently from holding an individual bond until maturity. Investors should understand what they own rather than assuming that every product labelled as a bond investment will provide the same stability.

Diversification cannot remove market risk

Diversification reduces dependence on a single company, sector, country or asset class. It does not guarantee that a portfolio will avoid losses during a broad crisis.

That distinction matters. Owning dozens of shares may offer little protection if they are all exposed to the same economy or industry.

A more robust portfolio may spread risk across domestic and overseas equities, high-quality bonds and cash. The purpose is not to own every available asset. It is to stop one source of risk from controlling the entire financial plan.

Investors should also consider risks outside their investment account. Someone whose salary, pension and shareholdings all depend on the same employer or sector may be less diversified than the portfolio statement suggests.

Use a realistic recovery stress test

Percentage losses and gains are not symmetrical. A portfolio that falls 50% must subsequently rise 100% to return to its starting value.

This arithmetic helps explain why recovery can take much longer than the initial fall. It also shows why selling after a severe decline can permanently damage a long-term plan.

A useful stress test is:

If my equity holdings fell by half and did not fully recover for five years, could I still meet my essential spending without selling them?

If the answer is no, the portfolio may rely too heavily on equities for near-term needs. Possible responses include building a larger cash reserve, using suitable high-quality bonds or reducing the overall equity allocation.

The stress test should also cover behaviour. A portfolio can be financially affordable but emotionally intolerable. If a large paper loss would cause an investor to abandon the plan, the original allocation was probably too aggressive.

Risk tolerance is best judged by what you could live with during a bad market, not by how confident you feel during a good one.

Decide on rebalancing before markets fall

Market declines can make every decision feel urgent. Written rules reduce the temptation to react to frightening headlines.

A basic investment policy might set target ranges for cash, bonds and equities, along with a schedule or threshold for rebalancing. It should also state when withdrawals will be taken from cash rather than shares.

Rebalancing is not a way to identify the bottom. It is a disciplined method of returning the portfolio towards its intended risk level.

Any plan must recognise practical limits. Cash reserves can be depleted, bonds can fall and equity recoveries can take longer than expected. The aim is not to create a portfolio that cannot lose money. It is to create one that remains workable when losses arrive.

Build for survival, not prediction

Preparing for a severe drawdown does not require a forecast about the next recession or bear market.

It requires clarity about when money will be needed, how much loss can be tolerated and what could force an untimely sale. Cash provides time, appropriate bonds can moderate volatility, and diversification reduces concentration risk.

Equities can still play the central role in long-term growth. They should simply be held at a level that allows the investor to stay invested through a difficult and potentially lengthy recovery.

This is general information rather than personalised financial advice. Investors who are uncertain about an appropriate allocation may wish to consult a regulated financial adviser.