Bear Market Jean Pierre Lavoie
Source: Jean-Pierre Lavoie via Wikimedia Commons.

The stock market's volatility has picked up lately. A steep decline in late September and early October reminded investors that stocks don't simply go up without interruption. Indeed, many market historians have noted that the 5-year-old bull market has seen few pullbacks along the way, and they're increasingly concerned that the market is overdue for a much larger drop. Should you prepare to defend yourself from what could be a massive destroyer of stock market wealth in the near future? Let's take a look at what history has to say about stock market plunges and whether you need to take steps to protect yourself now.

All we've seen so far is a minor correction
Market analysts tend to categorize stock market declines into three different groups:

  1. A full-fledged bear market only takes place when stocks fall 20% from their highest levels.
  2. Smaller declines of 10% from recent highs are referred to as corrections.
  3. Even tinier drops of just 5% are typically called minor corrections or more generic terms like pullbacks or downturns.

The stock market drop we've seen in the past month has seemed huge to many investors, with the Dow Jones Industrials (DJINDICES:^DJI) having fallen through two thousand-point levels in rapid succession. Yet when you look at the full extent of the move, the difference from top to bottom amounted to about 8% -- clearly qualifying as a minor correction and falling short of the 10% full-correction status that many have looked for. For the S&P 500 (SNPINDEX:^GSPC), the intraday low was more than 9% below the index's record high, but it rapidly bounced back from both of its approaches to full-correction territory.

Bull vs. bear. Source: Wikimedia Commons.

Where did all the downward moves go?
The amazing thing about the stock market in recent years is that it has been almost entirely devoid of downside volatility. The 5% correction we've seen so far is the first one for the S&P 500 since early February, and the market quickly bounced off that winter low to soar to new all-time highs within the following couple of months. Meanwhile, to find the last 10% correction, you have to go all the way back to June 2012, and we haven't seen a 20% drop since the stock market crash of the financial crisis.

That's a far cry from the typical levels of stock market movement. On average, minor 5% corrections have happened roughly three times every year, making them commonplace in market history. With the recent move being the second 5% drop in 2014, we're near the trend there, but recent years have also seen fewer minor corrections than normal.

Historically, larger 10% corrections have tended to occur on an annual basis. By that measure, we've gone almost two and a half times as long as normal without one, and some investors are fearful that the long period of stability has masked underlying pressure that could make a subsequent decline even worse.

Finally, bear markets have tended to come along every three or four years or so, making the current five-and-a-half-year span of the current bull market look like we've gone into overtime. Granted, it's far from unprecedented for a bull market to have lasted this long, and many past bull markets have lasted years beyond that average length. Nevertheless, it's fair to say that we're overdue for a major downward move, and the lack of small moves downward along the way has only given the major-market benchmarks further to fall in a reversal of fortune.

3 ways to stay on guard
Unfortunately, market plunges are like earthquakes in one important way: You know they're inevitable in the long run, but they're impossible to predict in the short run. If you make major changes to your portfolio to anticipate a future crash, you can end up being wrong for years, costing yourself huge returns in the process.

What you can do, though, is take steps to make sure your investments will keep working for you no matter what the market does. In particular, now is a good time to consider the following strategies:

  • Get your risk levels right. If you haven't made any changes to your portfolio in recent years, the odds are that, thanks to the stock market's run, you have a lot more money in equities now than you did five years ago, and thus your portfolio could be much riskier than you want. By rebalancing into lower-risk investments, you can effectively cash in on some of your gains while still maintaining the appropriate exposure to the stock market.
  • Look at big opportunities. Within the universe of stocks, high-growth companies have taken a much bigger hit than the market as a whole. The Russell 2000 (RUSSELLINDICES:^RUT) is in full 10% correction territory, and some of its components are starting to look like relative bargains compared to larger-cap stocks. Looking at areas of the market that you'd ordinarily neglect could pay off in the current environment.
  • Build up your cash. If you anticipate major expenses in the coming years -- whether from ordinary living expenses in retirement or a big-ticket purchase in the near future -- then taking advantage of relatively high levels in the market to sell assets and raise the cash you'll need could be a smart way to cut your risk. The last thing you want to do is put yourself in the position of having to sell stocks after a market plunge.

You won't be able to predict the timing of the next market plunge with certainty. But with many measures suggesting that we're overdue for a big drop, it only makes sense to take some time and make sure your portfolio is prepared to handle the pressure -- whenever it comes.
