Can your portfolio survive a market correction?

While some investors will be disappointed that the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) has produced a return of just 0.8% for the March quarter, there are reasons to view this meagre result in a positive light.

Firstly, it comes on the heels of an 11.4% rally in the index over the final six months of calendar year 2013 and a 32% rally over the past two years, so in this context the recent returns are reasonable.  Secondly, few investors would describe the overall market as cheap at present, which means a period of consolidation is not a bad thing to let some of the steam out of the market.

These factors certainly don’t mean that a major market correction is looming or that investors need to “run for the hills”, however stock markets are inclined to alternate between bull and bear markets and the longer this bull market continues, the more likely a bear market will emerge.

So what is the best way to position your portfolio so that it can survive a major market correction? Once again heeding the words of Warren Buffett can help. Buffett is fond of saying:

“Rule # 1, don’t lose money. Rule # 2, don’t forget rule #1”

It’s a catchy phrase but there is of course a deeper level of thinking to be applied. Consider what happens if BHP Billiton Limited (ASX: BHP) falls 20% from your purchase price. Initially, you might think you need the stock to bounce back 20% to be back to break even. This isn’t the case however; you actually need the stock to rise 25%. The situation gets even more acute the further BHP falls. A 33% fall will require a 50% gain, while a 50% drop requires a 100% gain to restore the stock back to your purchase price!

Realising the uphill battle which must be fought just to get back to a breakeven point makes it clear why Buffett aims to avoid losing money. It’s important to note that Buffett is referring to real losses – the kind you experience when you make a bad purchase decision and which can become most evident during a market crash. He’s not simply referring to quoted prices and advocating worrying about the ebbs and flows of share prices and the share market.

Foolish takeaway

So what types of companies give your portfolio the best chance of survival? Well first and foremost they need to be of a reasonable quality with a sustainable business model, companies such as Woolworths Limited (ASX: WOW) and Coca-Cola Amatil Ltd (ASX: CCL) fit the bill. Importantly though, they must also have been purchased at a reasonable price. Even a great company, if purchased far above its fair value, will leave your portfolio vulnerable in a severe correction.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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