Politicians, media personalities and writers seem to be constantly warning about an impending stock market drop. For investors, it can be hard to know what to do in response.
If you knew for sure that the value of your portfolio was going to drop in half tomorrow, you would want to sell all of your investments now. But when speculators are “crying wolf” so often, it’s clear that we cannot know with certainty what the market’s short-term movement will be. In fact, it's well documented that trying to time the market is never an optimal strategy for the retail investor.
Let’s define a worst-case scenario crash as an index dropping at least 50% from some previous high. Under this definition, there has been only one stock market crash since 1950 in the S&P 500 Price Index. Certainly, though, smaller drops occur much more often. This fact is reassuring, but it also shows how frequently the prognosticators are wrong.
Of course, a future stock market crash is a possibility, and even likely over the very long term. Here are the ways you can be prepared.
First, don’t invest too aggressively in the first place. Consider each of the following factors when choosing your investments. Invest based on:
Diversification
There is higher risk that a single stock or industry will experience a sharp drop than the broad market as a whole. You can also invest in asset multiple asset classes to reduce your portfolio’s risk. By investing in a diversified portfolio across multiple industries and asset classes, you protect yourself from risk that is unique to each company or industry.
The Financial Position You’re In
You should always consider your own goals first when making an investment decision. For short-term savings, to buy a new couch for example, consider just putting your money into a high-interest savings account rather than exposing it to market volatility.
If you are saving for your kid’s future college expenses, you will want to consider your family’s specific situation before choosing how to invest.
If you are retired, you may want to consider a lower percentage of equities, or stocks, in your portfolio since they can be more volatile.
Your Own Comfort
What is your own personal tolerance for volatility? If your portfolio drops significantly due to market changes, will you feel comfortable rebalancing your portfolio and continuing to invest until the market recovers? If not, you may want to consider a more conservative portfolio so that you will not be tempted to cash out after a dip in market values. This can cripple your returns and your confidence as an investor.
For some investors, a market drop is welcomed. Kate Braun, a writer for DollarSanity.com, says, "I actually love stock crashes. I see them as opportunities to buy in cheap to good companies." Her comfort with investment risk might be a lot higher than yours, and that's okay. Only you know your tolerance for risk.
Rebalance Your Portfolio
If the value of the equities (stocks, index funds, or corresponding ETFs) in your portfolio drops, then the remaining asset classes, like bonds, will then be a much larger percentage of your portfolio. To get back to your target allocation, you’ll need to buy more equities and sell some of your other asset classes.
Now, when the market recovers, you’ll be even better off than you were before since rebalancing caused you to buy more shares of the depressed equities while the cost was low.
Don’t Sell At “The Bottom”
If the broad market falls, you do not want to sell off your investments due to stress or panic. The market will recover eventually, and you will have locked in your losses. Instead, consider a bear market to be a buying opportunity.
Of course, choosing to sell or buy at “the bottom” of a crash implies that you know when you’re at the bottom. It’s not clear where the low-point in a crash was until after the market has recovered. I do not recommend any form of trying to time the market. Ever.
If you are retired, or semi-retired, you may want to hold additional cash reserves so that your living expenses will not require you to sell your equities after a crash. If you’re living off of your investments exclusively, I recommend keeping up to 3 years’ expenses in cash for this reason.
Understand The History Of The Stock Market
Past performance of the market doesn’t guarantee future results. But understanding the market’s past and trends can be very comforting. In the long-term, the market has been consistently rewarding for investors.
The S&P 500 index average annual return, since it began tracking 500 stocks in its index in 1957, is about 8%. So that’s exciting!
If you look at the details, though, there are a lot of ups and downs year-to-year. In the chart below, there is a lot of green and a lot of red. It’s very hard to know when a year will be “good” or “bad” in the moment.
The key to success in stock market investing is time in the market. So it’s critical that you invest only for the long-term and that you hold your investments. You won’t achieve that 8% long-term return if you sell your investments when the market goes down. In fact, you will probably miss the strong recovery years by doing so.
Being familiar with this data can also help you not be surprised when there is market volatility. Since you know the volatility will happen, you can avoid feeling panicked.
S&P 500 Historical Annual Returns Since 1927
Hold On Tight!
You are now equipped for a dip in the stock market. When the market drops, it still won’t be fun, but just remember to ride the roller coaster for the long-term.
We’ve covered a few steps to take when choosing your investments, and what to do when the market does drop. The most important thing is, don’t panic and sell. Keep buying, keep holding, and you’ll set yourself up for success when the market recovers.
