The prospect of a market crash gets more attention than it should.
Nonetheless, it's a constant possibility. Here are some steps you can take to protect yourself.
Market crashes are far more common in our imagination than in reality. This is because they are vivid and scary events.
Given our evolution, we are wired to worry about these sorts of vivid events. While, this may have been useful in helping us avoid getting eaten by tigers, it's less useful for rational, disciplined stock market investing.
By thinking this topic through now, hopefully you're a little better prepared when the next crash hits.
Prepare
Preparation is key.
The best time to react to any potential market crash is before it occurs. Not after. Reacting in the moment can lead to expensive and costly mistakes. For example, if you saw that socks were on sale, you'd be more interested in buying socks. However, when it comes to stocks, people take a different view.
When stocks are on sale, as can occur in a market crash, then often investors' instincts are to run away.
Thinking about your strategy ahead of time and writing it down, just in a couple of paragraphs, can be key.
Then if the markets do crash, make sure to look at that document before you act.
In a sense, it's understandable why panic occurs. In fact, one key ingredient for crashes is often panicked investors.
First off, there is typically something big and scary associated with a crash. Yet, it's often temporary.
It's important to remember that the markets have endured world wars, nuclear weapons, disease epidemics, inflation spikes, mass unemployment and presidential assassinations and in each case global markets have generally come back to make new highs.
Though we don't know what will motivate a future market crash, it's likely to be something that will ultimately be recovered from if history is any guide. The economy and society are very flexible. Industries, and even countries, can rise and fall over time, but if you have a global, well-diversified and lower cost portfolio, then you should be well-positioned.
This is an area where diversification helps. If you spread your bets it will likely help.
You'll probably find that the next crisis centers on a specific country, part of the globe or investment theme.
If you've spread your bets through diversification, then you'll undoubtedly have some assets that fall in value, perhaps alarmingly, but often certain assets can do well during certain crises such as high-quality bonds, more defensive or inexpensive parts of the stock market, or commodities including gold.
Crashes are a fact of life
Rather than trying to time the market, which is incredibly hard to do and often counterproductive, it can be helpful to remember that the attractive long-term returns to the stock market include many market crashes. Depending on your measurement criteria, time-period and exactly what index you look at well-diversified portfolio have averaged returns of around 6%-10% a year over time.
Of course, that's an average and the market's return is seldom steady and predictable.
Yet, it's important to remember that these attractive returns include many periods when the markets have lost a quarter or half their value, or worse. As a result, even if you know a crash is coming at some point, which it very likely is at some point in the coming years, then it's not a reason to avoid stocks.
Provided you can stick with it you'll likely see decent returns from diversified global stocks even including the catastrophic crashes that scare you.
Sort out your allocation now
Now is the time to make sure you have a portfolio that you could live with through a crash. A typical crash will feel very different if you are 100% invested in stocks, than if you have some of your portfolio invested in bonds and other assets.
The time to work out the right allocation for you is now, if you determine that you should not be completely in stocks but would rather have a 60%/40% stock/bond allocation, then it's critically important to determine that before a crash occurs. If you don't, you'll experience the worst of both worlds. You'll likely see the greatest losses during the crash, but also fail to benefit fully from any recovery. If you prepare ahead of time, you'll be better able to ride out any market events.
There are a few things to bear in mind here.
The first is that investors can overestimate their ability to endure losses during the good times.
So be a little more conservative in your allocation than you might think. Also, it's not just about having nerves of steel, it's also about how soon you'll need the money in your portfolio. Even if you are a fearless and disciplined investor, it doesn't matter if you need to spend down a big chunk of your portfolio each year.
Regardless of your temperament you'll be a forced seller in a weak market, and therefore, considering having some of your assets more conservatively positioned so that they are a more robust source of cash when you need them can make sense.
Allocation tips
Finally, as you think about your allocation there are a few things to consider. Generally, lower risk bonds hold up better during stressed markets. U.S. Treasury bonds have historically risen in value during extreme market stress.
It's not guaranteed but may be helpful to portfolios if history is any guide. Also, depending on the nature of the crisis diversifying assets such as commodities, including gold, or real estate can be helpful. Again, these won't work every time, for example in 2008-9 real estate was the epicenter of the crisis but spreading your bets can help.
Finally, within stocks diversification is useful. We've seen high valuations in U.S. blue chips in the 1970s, U.S. tech in the 1990s and Japanese investments in the 1980s, each was met with nasty price declines on the other side. Rather than trying to predict these events, it can be best to spread your bets across sectors, geographies and other categories, so that if the next crash does focus on one specific area, then you won't be wiped out.
So, the way to prepare for a market crash is not necessarily to artfully predict in and step aside when the crash comes.
That's virtually impossible. Rather, it can be useful to consider your overall investment strategy ahead of time, so that you know you could stomach the next inevitable crash when it comes. Ideally, through proper diversification and forethought you'll have an investment approach that will enable you to ride out a crash, rather than turning you into another panicked seller. If you only act on these issues when the crash comes, it will likely be too late.
