We've all heard the term cut your losses. You hear people use it to describe any number of things. It might be referring to a bad relationship (friendship, marriage, work, etc.). It could be in a specific investment (stock of a particular company, business, real estate, etc.). With the longest bull market in history still going, many are talking about the prospects of a significant market correction.

Really, the conversation is more about a recession and a bear market. A bear market has a pretty well-accepted definition – a 20% decline in stocks. A recession, on the other hand, is much debated. We won't get into that debate today. It is, however, safe to say that bear markets and recessions are closely related. Sometimes bear markets come before a recession, sometimes after.

DQYDJ (Don't Quit Your Day Job) shows that 7 of the last 11 bear markets either preceded or followed recessions. With the current long-running bull market, there is more and more talk about both. Are we headed for a recession? A bear market? A market crash?

The simple answer to all three questions is yes.

The next bear market

What people want to know is when the next recession/bear market will arrive. That's a question that is difficult, if not impossible, to answer. I've been saying for at least a couple of years now that we're overdue for a downturn. By downturn, I don't mean the little hiccup we had in Q4 2018. I'm talking about somewhere between that and the 2008 financial crisis downturn.

Yeah, yeah. I know. That's pretty negative. Or as Zig Ziglar would say, “stinkin' thinkin'.” Fair enough. I've been around long enough to know the current market is unsustainable. It's the equivalent of living on a sugar high (low-interest rates, a growing economy, low jobless rates, etc.).

I also know (and I bet you do too), that something has to give. We cannot continue double-digit yearly gains in the stock market forever. I know some younger investors know nothing else but this market. I've asked the question in the past whether they are emotionally prepared for a market meltdown. Many newer investors freaked out a bit in Q4 of 2018.

Ok. With that long-winded pontificating out of the way, let's get to the core question – should you have a plan to cut your losses in a bear market (recession, crash, whatever you want to call it)?

The answer is – yes. But it's probably not what you think it is. Here are my thoughts.

Avoid making emotional decisions

The biggest mistake I see investors make is taking too much risk in their investments. That usually happens in markets like the current long-running bull market. You see double-digit returns every year, and you want more of that. So you increase your percentage in stocks and go for it. Or if you're already 100% in stocks, you get even more aggressive with the companies/funds you own.

It happened in dramatic fashion in 2000 when the “dot com” stocks rose to levels that made no sense. It happened again in 2008, just before the financial crisis hit and the S & P 500 dropped over 37%. Most of the stock-buying frenzy comes out of FOMO. Fear of missing out causes people to make terrible decisions.

Ordinarily cautious, conservative investors hear the constant media drumbeat of how the market continues to go up. They listen to it from their neighbors, friends, and coworkers. Eventually, FOMO kicks in and pushes them to invest.

John Maynard Keynes gets credit for saying, “the markets can stay irrational a lot longer than you can stay solvent.” Keep this in mind when thinking about investing. It could help you avoid making investment decisions you will regret.

Volatility comes with investing in the stock markets. How you deal with the volatility determines how well your investments perform over time.

Invest as if a market crash was imminent

What do I mean by that? Ask yourself this question. If you knew the market was about to crash, would you invest the same way you are now? The obvious answer to that is, of course, no. If we could predict when the crash was coming, we'd all get out of stocks right before. Thank goodness that doesn't happen. No one would recover from that.

Here's what I recommend. Make sure you put your investment portfolio through a stress test. If you're working with an advisor, chances are they will promote how much the funds they recommend have made over the years. Often, they show those numbers as average annual returns. Average annual returns don't represent a potential worst-case scenario.

Look at how the portfolio would have performed in the 2008/early 2009 market environment. Would it have been down 10%? 20%? 3o%? Whatever the number is, ask yourself how that would make you feel. Though percentages are helpful, the real measuring method that matters is the amount of paper loss of money that percentage represents.

Real money

Let's say you have a $500,000 portfolio that drops by 10%. Of course, that means your $500,000 portfolio is now worth $450,000. A 20% drop makes it worth $400,000, and so on. Looking at real dollars puts things in a different perspective than a percentage. It shows the real money involved. Any drop in portfolio value needs to pass the stomach test.

What does that mean?

If, when you look at the drop in dollar value of your portfolio, you get a queasy feeling in your stomach, you've failed the stomach test. You're probably taking too much risk. If you feel nauseous or panicky during these times (or thinking about these times), it often leads to irrational, costly emotional decisions.

Do yourself a favor – TAKE THIS TEST to see if you have the right investment mix.

Stick to your investment strategy

Famed investor Warren Buffet has a simple rule of investing – “Rule #1 is never lose money. Rule #2 is never forget Rule #1.” Times of heightened market volatility can cause you to question your investment strategy. If you do, be very careful.

In the 2008 financial crisis, many investors allowed fear to guide their investment decisions. They didn't follow Warren Buffet's advice and sold their stock holdings at the worst possible time. During that period, Mr. Buffet was buying vast amounts of companies that had fallen on hard times during the financial crisis. When other people were selling, Mr. Buffet was buying.

This article, written in 2013 says that Warren Buffet made over $10 billion from investments he made during the financial crisis. Imagine what those investments are worth today!

Mr. Buffet follows the age-old investment wisdom of buying low and selling high. If you're selling when the market is falling, you're doing just the opposite. If your stomach gets queasy during times of market volatility, you're portfolio probably has more risk than it should. The worst thing you can do is to sell stocks when the market is dropping. When your stock holdings (whether individual stocks or mutual funds) are falling, consider buying more of them. If it's good enough for Warren Buffet, it should work for you as well.

When you're investing in individual stocks, make sure they are good quality business. If you invest in bad companies just because the market is down, you're still investing in bad companies.

For most people, broadly diversified, low-cost index funds are the best choice. Even Warren Buffet recommends index funds for most investors.

The cut your losses strategy

Ok, here's where the surprise comes into play (maybe not for all of you). If you're not supposed to sell when the market drops. If you can't time the market, what's the solution? Whether you're a beginning investor or a seasoned investor, the answer is the same.

Have a rebalancing strategy.

I know. I know. That sounds so boring and pedestrian Most successful long-term investors follow this boring strategy. They either buy good companies, stick with them for the long term and buy more when they're down. Or they buy low-cost mutual funds that buy good companies and do the same with them.

What is rebalancing? I'll assume you have a target allocation for your investments, meaning you have specific percentages you want to have in various asset classes. A rebalancing strategy says that when those allocations get above or below the targeted percentages by a certain amount, you will sell those that passed the highest limits and buy those that crossed the lowest limits. Those percentages above and below the targets are different for everyone.

If you're comfortable with more range, you might choose 25% as the upper and lower limits. If you want to be more conservative, you might choose 20% or even 15% ranges. Keep in mind that the smaller the percentages, the more you would be buying and selling. That increases trading costs.

How is that cutting your losses? Simple. Rebalancing is an incremental way of executing a buy low sell high strategy. When asset classes get outside the accepted top targets, you sell some of them to bring them back to the acceptable range (sell high). Conversely, you put that money into an asset class that falls below their low-end targets (buy low).

It's an incremental way to do what Warren Buffet says – buy when everyone is selling. Sell when everyone is buying.

Final thoughts

Surviving a market correction, or even a market crash, does not have to be complicated. If market drops put you into a panic, you probably shouldn't own stocks. At the very least, you should consider reducing your risk.

Volatility is part of what comes with investing in the markets. The worst strategy you can have is to follow the crowd. Don't sell because everyone else is selling. Conversely, don't buy when everyone else is buying. The herd is seldom right.

Invest in the markets for the long-term. Taking actions based on short-term market activities rarely turns out well. Stick to your investment strategy. Have the courage to buy when everyone else is selling, with the caution of only investing in great companies or funds that own great companies.

Trust what the history says about the long-term investment returns the markets offer. Turn off the financial news. Ignore the doomsday headlines. Go hug your wife, significant other, partner, or your dog and tell 'em you love 'em.

Now it's your turn. Have you put your portfolio through a stress test? Does it pass the stomach test? Have you prepared for a worst-case scenario? Let me know in the comments.