The S&P 500 Correction Illustrates the Importance of Risk Tolerance

Taking a look at your investment portfolio right now might not be the most reassuring experience. Stock markets have been experiencing sharp declines as investors attempt to assess the consequences of President Donald Trump’s tariffs and economic policies. The S&P 500 closed in correction territory this week for the first time since October 2023, marking its fourth consecutive week of losses.

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According to José Torres, a senior economist at Interactive Brokers, this downturn has sparked investor anxiety, leading some to step away from the market. What makes this particular selloff unexpected is the initial optimism surrounding Trump's economic impact. Following his election victory in November, markets surged as investors anticipated that his promises of tax cuts and deregulation would drive stock prices higher. Many retail investors expressed bullish sentiments heading into 2025.

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However, once Trump took office, his administration prioritized imposing tariffs to address the U.S. trade deficit. This shift in focus unsettled investors, who worried about potential economic challenges stemming from trade disputes, leading to declining stock prices.

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The abrupt nature of the market downturn has made the situation particularly difficult for retail investors, many of whom have become accustomed to rising markets. “Retail investors are really conditioned to be long. They know how to make money in ‘up’ markets,” Torres explained. Over the past two years, stocks have trended mostly upward, making a buy-and-hold strategy highly effective. But with recent volatility and intraday price swings, Torres suggested that retail investors consider alternative strategies to navigate neutral or declining markets.

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Institutional investors often employ more advanced strategies to manage market downturns, including covered calls, short strangles, short selling, and put options. Among these, short selling is one of the more straightforward but risky tactics—it involves borrowing shares, selling them immediately, and repurchasing them at a lower price if the stock declines. Another approach is buying put options, which gives investors the right to sell shares at a predetermined price, benefiting from a market decline.

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While these strategies require more sophistication than traditional buy-and-hold investing, understanding them can help investors feel more confident when markets decline. That said, such approaches are better suited for active traders willing to take on additional risk. Many retail investors prefer a hands-off approach, and for them, focusing on long-term market trends may be a better strategy.

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Stock market corrections and even bear markets are a normal part of investing. However, history shows that a 10% decline in the S&P 500 does not necessarily lead to a deeper 20% bear market, and over time, markets tend to recover. In the past 15 corrections, the index was higher 60% of the time three months later and 86.7% of the time after one year.

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Yung-Yu Ma, chief investment officer at BMO Wealth Management, believes market downturns offer an opportunity for investors to reassess their risk tolerance. “Stock-market pullbacks do occur, and it’s important that investors align their portfolios with their risk tolerance,” Ma noted. He emphasized that investors should avoid panic selling but use market declines as a chance to align their investments with their long-term financial goals.

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Many investors unknowingly take on more risk during bull markets, as rising valuations create potential pitfalls. Torres pointed out that when stock valuations become extended, investors are essentially making optimistic projections about future earnings, which increases overall market risk. For example, last year’s surge in price-to-earnings ratios for companies like the “Magnificent Seven” tech stocks made those investments more vulnerable to downturns.

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Recent surveys indicate that retail investors are increasingly concerned about high stock valuations. A Charles Schwab survey found that many of its clients saw stretched valuations as a major issue, making it harder to find attractive investment opportunities. While this hasn’t necessarily led to widespread selling, more investors are exploring options-based strategies to hedge their positions.

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The current market pullback has slightly eased valuation concerns, but investors still have an opportunity to refine their strategies. Joe Mazzola, Schwab’s head of trading and derivatives strategy, advises investors to conduct factor analysis and pay close attention to valuations when selecting stocks. “Make yourself a list,” Mazzola suggested. “Focus on stocks where you understand the business model, the demand for their products, and their financial fundamentals. Identify technical or fundamental levels where prices become attractive for entry.”

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Mazzola explained that narrowing one’s focus can make investing more manageable rather than trying to track the entire market. Despite the challenges of market corrections, they also present buying opportunities. Lower stock prices allow long-term investors to acquire high-quality companies at a discount—opportunities they may have missed during a bull market.

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“In the initial phase of a market pullback, even companies with strong fundamentals can experience sharp declines,” Ma explained. “But as selling pressure eases, those stronger companies tend to stabilize, which is often a sign that market risks are beginning to subside.”

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Despite a strong rebound in stocks on Friday, major U.S. indexes still posted losses for the week. The Dow Jones Industrial Average declined by 3.1%, the S&P 500 dropped 2.3%, and the Nasdaq Composite shed 2.4%.

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Investor sentiment remains cautious following recent tariff developments, and market participants are watching for further policy updates. Additionally, the Federal Reserve’s next meeting is scheduled for March 18-19. While rate cuts are not expected, investors will closely analyze the Fed’s outlook and any insights from Fed Chair Jerome Powell’s post-meeting press conference.

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