MW The S&P 500 correction shows why risk tolerance matters. These strategies can get investors back on track.

By Gordon Gottsegen

The stock market's reversal was a 'nasty surprise' for retail investors

Looking at your portfolio right now might not feel very good.

Stocks have been tumbling lately as investors try to anticipate the impacts of President Donald Trump's tariffs and new economic policies. The S&P 500 SPX closed in correction territory this week for the first time since October 2023, and just clocked its fourth consecutive week of declines.

"I think that the sharp comedown really generates some level of investor panic and can lead them to stay away for some time," José Torres, senior economist at Interactive Brokers, told MarketWatch.

According to Torres, what makes this specific stock-market downturn a "nasty surprise" is the expectations that investors had for President Trump's impact on the economy.

Markets rallied after Trump won the election in November, as investors anticipated that his campaign promises of tax cuts and deregulation would boost the stock market. According to one survey, the majority of retail traders felt bullish about the stock market going into 2025.

But once Trump entered the White House, some of his initial economic priorities focused on imposing tariffs to address the U.S.'s trade deficit. Investors began worrying that these tariffs could create economic headwinds, and stocks reacted by moving lower.

Read more: Are we now in a stock-market correction, pullback or bear market? Here are 6 charts to watch.

The sudden nature of the stock market's reversal may have made the drawdown feel even worse, especially for retail investors.

"Retail investors are really conditioned to be long. They know how to make money in 'up' markets," Torres said.

He added that for the past two years, the market primarily moved in one direction: up. This meant a long-only strategy worked well. But with the market moving downward over the past few weeks and seeing a lot of volatility and intraday swings, Torres said it may be a good time for retail traders to learn how to make money in neutral or down markets.

He pointed to some complex strategies that institutional investors deploy during such markets - like covered calls, short strangles, shorting and buying puts.

Perhaps the most straightforward of these strategies - but also potentially dangerous - is shorting, or short selling. It involves borrowing shares, immediately selling them, and then buying them back at a later price. If the price of the stock drops, the investor makes money because they're able to buy back the stock for less than they sold it.

Buying put options is a similar strategy that benefits when a stock price goes down, because it allows the investor to sell shares at a predetermined strike price.

Although these strategies tend to be more sophisticated than simply buying and holding, learning how to profit in any kind of market may help investors get more comfortable with drops.

These kinds of strategies tend to be more appropriate for retail investors who have the desire to trade actively, so they might not be for everyone. They also introduce a level of risk that some investors may not be comfortable with.

As Torres pointed out, a lot of retail traders are primarily long, buy-and-hold investors. But for those who prefer to remain hands-off in their approach, there are ways to move forward, too.

The long-term approach

Stock-market corrections do happen, as do bear markets. But history shows that a 10% drop in the S&P 500 doesn't always lead to a deeper 20% bear-market drop, and markets tend to recover over time. Of the last 15 corrections for the S&P 500, the index was higher 60% of the time after three months, and 86.7% of the time after one year.

Yung-Yu Ma, chief investment officer at BMO Wealth Management, thinks that stock-market drawdowns give investors the opportunity to actually figure out what their risk tolerance is.

"Stock-market pullbacks do occur, and it's important that investors align their portfolios with their risk tolerance. Often it is amid such pullbacks that investors get a better sense of where that tolerance actually rests," Ma wrote in an email. "Investors shouldn't panic sell, but they should look for opportunities to align portfolios with their longer-term goals."

This reassessment of risk tolerance could be worthwhile because investors may be adding risk to their portfolios during bull markets without realizing it. As Torres noted, equity markets with higher valuations tend to introduce more risk.

"The more extended valuation multiples get, the more risk you're taking as an investor because you're projecting earnings out into the future," Torres said.

For instance, as price-to-earnings ratios grew more elevated for companies like the "Magnificent Seven" Big Tech stocks last year, the riskier they got for investors.

Last month, brokerage Charles Schwab $(SCHW)$ surveyed its clients and identified high valuations as one of their biggest concerns.

"The market's rich - it's hot, it's overvalued," Joe Mazzola, Schwab's head trading and derivatives strategist, told MarketWatch.

According to Mazzola, Schwab customers said they weren't finding as many investing opportunities given that dynamic. And while that didn't necessarily mean they were going to sell, Mazzola said that more Schwab customers were interested in buying options to hedge their positions.

The current market pullback has deflated those high valuations a little bit, but Mazzola said this still could be a good opportunity for long-term investors to do some factor analysis and pay attention to things like valuation when figuring out what stocks to buy.

"Make yourself a list," Mazzola said. "Some stocks where you understand the business model, you understand what it is that they produce and what the demand is. Use that and look for levels - whether it's on a technical level or fundamental level - where if things become attractive to you, you use those as your entry points."

Mazzola said that this strategy of narrowing your focus can be easier than trying to track all stocks across the market. Because even if corrections can cause carnage, they also create buying opportunities. Lower valuations give newer investors the opportunity to buy high-quality equities at a cheaper price point - something they may have missed out on during a bull market.

"In the first stage of a stock-market pullback, many companies with strong prospects sell off more than warranted," Ma noted. "In the next stage of selling, those stronger companies tend to stabilize, which can be a sign that some risk is starting to abate."

Despite the rally for stocks on Friday, the major U.S. indexes ended lower for the week. The Dow Jones Industrial Average DJIA lost 3.1% on the week, the S&P 500 fell 2.3% and the Nasdaq Composite COMP shed 2.4%.

Tariff news shook investors throughout the past week, so investors may be looking for further updates to economic policy in the week ahead. On top of that, the Federal Reserve's next policy meeting is scheduled for March 18-19. Although the Fed isn't expected to cut rates, investors will be paying attention to what comes out of the meeting, as well as Fed Chair Jerome Powell's postmeeting press conference.

-Gordon Gottsegen

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March 15, 2025 07:30 ET (11:30 GMT)

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