An Investment Lifeboat Drill Now Can Help Weather Future Disaster

Calm water makes a lifeboat drill much easier. We aren’t fighting the waves or the fear we feel during an emergency. Still, if the worst happens, and the drill becomes reality, at least we’ve rehearsed. We’ll know exactly what we are supposed do.

With the markets relatively calm, now is the perfect time for an investor lifeboat drill. But to get the most out of this drill we need to remember how we felt seven years ago when the markets were getting scary.

Remember the days when even smart, reputable people shouted gloom and doom from the rooftops? If not (or if you’ve blocked it out), let me give you the abridged version: It was terrifying.

The United States government was bailing out private companies that were “too big to fail.” We were reading shocking headlines on a regular basis:

Stocks Take Record Tumble, Down 777 Points

For Stocks, Worst Single-Day Drop in Two Decades

How Low Can The Stock Markets Go?

With those memories and emotions in mind, let’s start the first drill.

Take out a blank piece of paper. Grab two Sharpies, one red, one black. Write $250,000 in black in the upper left corner. Then, write $225,000 in the lower right corner. Use the red Sharpie to draw a down arrow from left to right to represent a market drop of 10 percent. How do you feel?

It’s probably feels a little uncomfortable, but you’re prepared. You’ve read about market corrections. During the last 70 years, markets have undergone 27 corrections. They aren’t unusual. You’ll buy stocks through the dip, perhaps through automated purchases through a retirement account.

For the second drill, pull out another piece of paper. Write $250,000 in the left corner and $200,000 in the right corner. Draw a scarier red arrow because now we’re talking about a loss of 20 percent.

Things are more serious at 20 percent. After all, market declines of 20 percent or more qualify as bear markets. But you’re still O.K. You’ll grit your teeth and continue to buy more stock at regular intervals because you believe Warren Buffett, who says you should be greedy when others are fearful.

The third drill will prove the most challenging. We’re going to focus on the “or more” part of the last drill. Think back to the market highs in 2007 and the market lows in 2009. The broad stock market index dropped over 50 percent. Write down those numbers on a third piece of paper. That’s $250,000 and $125,000. What will you do?

We know what many people did last time. They jumped overboard instead of getting into the lifeboat. History shows us the markets recovered. However, right at that moment, they just wanted the pain to stop, so they sold all their stocks.

I understand that this lifeboat drill seems academic, maybe even a little silly. Why do we need to think about what the markets might do? Sure, they’re not really doing anything right now. But that could change at any time.

To be clear, I’m not predicting a correction or stating that we’re in the midst of a bubble. I don’t appear on television often enough to predict something like that. Since 1945, however, we’ve averaged one correction every couple of years. We haven’t had a correction of 10 percent or more in roughly 43 months.

Even if we plan to buy through the next dip, no matter how big or small, we’re fools if we miss the opportunity to practice how we’ll react. The correction might only be a 10 percent decline. But it might be 40 percent. We don’t know, and that’s the point.

Don’t treat this exercise like the fire drill at work where only half the people leave the building. Give serious though to your investments. How would you react if any of your lifeboat drills became reality? Could you make yourself buy during a scary market?

Have a conversation with someone you trust, like your adviser or spouse or best friend, to talk through the options. Build a portfolio with a broad mix of investments that might help keep you from jumping overboard if they all don’t fall at once. If there’s even a possibility that you might have a hard time staying in the boat, now is the time to figure it out.

This commentary originally appeared May 18 on NYTimes.com

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© 2015, The BAM ALLIANCE

Carl Richards, CFP®

Carl Richards is the creator of the weekly Sketch Guy column in The New York Times and is a columnist for Morningstar Advisor. Carl has also been featured in The Wall Street Journal, Financial Planning, Marketplace Money, The Leonard Lopate Show, Oprah.com and Forbes.com. His simple but meaningful sketches served as the foundation for his first book, "The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money."

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