How will the active fund manager or the passive index rules respond during a market correction?  Investors should review the process that each fund or ETF follows in the management of its investments. Are decisions based on experience and discretion or are decisions determined by unbendable rules? What triggers changes in allocations or holdings? Does a price decline of a certain magnitude trigger a change or does change only occur at specific intervals? It is not only essential to understand a manager’s or an index’s approach to reducing or changing market risk and exposure, but also to comprehend how risk and exposure is reintroduced.

How will the financial advisor respond during a market correction?  Financial advisors have to ask themselves if each portfolio, allocation, and strategy matches the time horizon, financial capacity, and risk tolerance of each client. Most financial advisors hold the keys to a client’s asset allocation. This is the most significant key to ultimately meeting a client’s financial objectives. Is the advisor expected to make the decisions about dynamically increasing or decreasing market exposure?  Is this decision outsourced to fund managers or ETFs? For some advisors, clients expect the allocation to change as markets change.  If so, what are the rules and procedures for making changes? For other advisors, client asset allocations are set and are not expected to change, even in the face of significant market decline. How will advisors help themselves and clients avoid behavioral mistakes in the teeth of a correction? Will the advisor be willing to stand firm in the face of concerned client? In some cases, financial advisors anticipate that a client will be unhappy with the performance of the portfolio. In these cases, advisors may attempt to preempt these concerns and suggest unnecessary changes.

Is each position the right size within the portfolio?  Position sizing is one of the most important roles that a financial advisor can play for a client.  For example, an advisor may have a 30% strategic allocation to an equity growth strategy. After a 10%-20% decline, would the advisor or client reduce the exposure to 15%?  If so, it would be better to give the equity growth strategy an allocation of 15% as the initial allocation and live through the correction or bear market without making changes. A strategic allocation is different from a dynamic or tactical allocation that potentially reduces exposure as the position declines. Dynamic strategies will be susceptible to false alarms. Will the advisor allow the strategy to work as designed, despite getting defensive more often than is ultimately necessary?

Related: International Investing: “You Must Unlearn What You Have Learned”

How will the investor or client respond during a market correction? Can the client live through a market correction (or worse) without demanding changes? The behavioral mistakes associated with clients strategically moving from an aggressive risk profile during market rallies to a conservative risk profile during market declines is a quick path to wealth destruction. Does the client have appropriate return assumptions and realistic risk management expectations? Defensive strategies and asset allocations have the potential to reduce or cushion declines, but they rarely eliminate losses during market corrections and bear markets.  Clear, realistic communication between advisor and client is a common theme in the successful navigation of market rallies and declines.

Whether a correction happens soon or is still years away, it is time to review your market correction checklist.  In our opinion, the ideal investment allocation is the one that the advisor and client can live through.

John Lunt is the President of Lunt Capital Management, a participant in the ETF Strategist Channel.

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