3 Questions to Answer Before the Market Plunges

With a big bull market in stocks that has lasted more than three years now, memories of what a falling stock market is like are fading into the past. Sooner or later, though, you can count on a more serious downturn. By the time it comes, it'll be too late for you to take all the best steps to prepare for it. The best time to prepare for a downturn is before it happens, because it lets you flesh out a strategy to follow while you're still calm enough to consider all your possibilities -- and pick the best ones for your financial situation.

Below, you'll find three things to ask yourself in order to get ready for the next bout of market volatility. It could happen next week or take years to occur, but either way, having your plan in place will make you feel more comfortable with your finances. It could also save you from making big mistakes.

The first question to consider is whether you actually want the market to decline. As Warren Buffett has said repeatedly, long-term investors who plan to add money to the market over their lifetimes should actually want stocks to go down, as declines let them buy more shares with the money they invest in the future. On the other hand, if you're near or in retirement, you may not have more money to invest and instead be looking for auspicious times to reduce your stock exposure.

If you plan to put more money into the market, then part of your pre-crash planning is to have cash on hand to take advantage of bear markets when they come. That means having a cash cushion for investment, even with interest rates near zero, in the hopes of grabbing potential bargains.

On the other hand, if you're looking to cut your stock exposure and take a more conservative stance, now's a good time to consider making a move. With stocks trading at relatively high levels, you want to make sure you reduce your exposure to a comfortable level without having to dump shares in a fire sale after a decline.

Bullish moves create higher risk, whether you're talking about stocks, bonds, or other red-hot investment categories. Make sure you're comfortable with how much of those investments you own.

For instance, mortgage REITsAmerican Capital Agency (NAS: AGNC) and Annaly Capital (NYS: NLY) boast extremely favorable dividend yields, although Annaly has seen share-price declines that have offset much of its dividend payments. But the bigger risk going forward is the impact that narrowing interest-rate spreads could have on their business models. Both mREITs have already cut their dividends, and further cuts could endanger investors' gains going forward. Similarly, owning too many bonds right now carries the same interest-rate risk.

In most down markets, a few stocks nevertheless perform well. But which stocks are the winners depends on the cause and type of market decline.

In 2008, the recession combined with the financial crisis to create an environment in which consumer spending was at serious risk. That's why bargain-oriented companies McDonald's (NYS: MCD) and Wal-Mart (NYS: WMT) had such solid performance from their stocks, because they each tapped into that trend. By contrast, Starbucks (NAS: SBUX) found itself priced for collapse because of its perception as a high-priced luxury item.

Whatever causes the next crash may be completely different, making other stocks the winners. If Europe is the cause, then internationally insulated businesses might prosper by focusing on their domestic customer bases. If higher rates come, then companies with big cash balances on hand could gain competitive advantages over their more debt-ridden peers.

But by keeping your eye on overall economic conditions, your best guess on what may cause the next bear market will improve your chances of finding investments that will do well despite it. That could make the difference between huge losses and modest gains -- even in a down market.

Last but not least, mentally prepare yourself to watch your investments lose value, at least temporarily. You need to have the courage to stick with your plan when a market plunge actually happens. Stress-testing your emotional response now will leave you much more ready to weather the storm when it hits.

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At the time thisarticle was published Fool contributor Dan Caplinger is as ready as he'll ever be for the next bear market. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital, Starbucks, and Wal-Mart. Motley Fool newsletter services have recommended buying shares of Wal-Mart, Annaly Capital, Starbucks, and McDonald's, as well as writing covered calls on Starbucks and creating a diagonal call position in Wal-Mart. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy always weathers the storm.

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