Five Ways to Prepare for the Next Market Dip

Whatever triggered that mysterious thousand-point stock market tumble on May 6 — a "flash crash" that briefly vaporized some $1 trillion — it served one good purpose: After 13 months of remarkably steady gains, we were all reminded that the market is inherently volatile. Though stocks tend to beat other investments over decades, seldom do they move smoothly upward for long. The stock market is, by nature, a roller coaster.

And really, how could it be otherwise? The market measures our collective greed and fear, and the persistent worry lately is that, despite some promising signs, the worst global economic downturn since the Great Depression isn't over — that we may be headed for a second trough.

This doesn't mean you should abandon stocks. On the contrary, you need their higher long-term returns to build your retirement savings. You just have to learn how to ride out the losses. Remembering these five market truths will help.

1. The market knows much less than you think

Stock prices aren't a mirror held up to the present. The market reflects investors' guesswork about what might happen tomorrow, next week, or six months from now. The disconnect between the two became particularly clear when the economy tanked. In 2009 we were deep in a recession that cost more than 8 million people their jobs, and housing prices had taken their biggest dive since the 1930s. Yet from its low in March 2009 to its high in April 2010, the S&P 500 Index rose an astounding 80 percent — a speculative bull market fueled largely by the Federal Reserve's near-zero interest rates. This is why trying to buy stocks at the bottom and sell them at the top is so hard. Sometimes stocks command more than they're worth, sometimes less. Your best strategy is called dollar-cost averaging: Invest the same amount regularly so you get fewer shares when prices are high and more when they are low.

2. Professional traders are short sighted

In May a crop of genuinely upbeat economic news — a little more hiring, stabilizing home prices, rising consumer confidence — offered signs of a nascent recovery. At the same time the stock market plummeted. The S&P 500 Index lost 10.5 percent — its biggest one-month drop in decades. The nosedive was a nervous reaction by institutional traders to bad news from Europe — especially the fear that Greece would default on its debts, triggering a new chapter in the financial crisis … and perhaps the recession's second dip.

Stoking the panic was German chancellor Angela Merkel’s reluctance to embrace a European Union bailout for Greece. She was concerned about a regional election and didn't want to alienate German voters. By hanging tough, she helped drive up lending rates in Europe, which frightened the U.S. stock market. Then Merkel agreed to a bailout, and the stock slide abated along with immediate fears for Greece — proving once again that investing based on the market's gyrations is a recipe for emotional and financial whiplash.