Before we go any further with this, we need to set some ground rules when it comes to discussing a stock market crash.
First of all, nobody knows when the next stock market crash will occur. While many will try to convince you otherwise, predicting the next crash is impossible. Warren Buffett explained this best when he said that market forecasters are out there to make fortune tellers look good.
Second of all, timing the market is impossible. A lot of people come up with this idea that they will be able to exit and reenter the market at the perfect time. While this idea looks good on paper, it probably won't turn out like this. The reason behind this is because of what we already mentioned. You have no idea when the market has reached a top or a bottom.
Third and finally, no action is necessary on your part. If you want to take steps to prepare for a market crash, you can. However, this is not required. When it comes to investing, activity is often times the enemy. Emotions get involved when stocks are making drastic price moves, up or down and this often results in poor decision making. When it comes to the stock market, one of the best things you can do is often to do nothing at all.
What Is A Stock Market Crash?
The words crash, correction and bear market are often used interchangeably. It is important to understand the difference between these. While there is no official definition, here is what most people agree on.
A correction is a very frequent occurrence. This is a drop of around 10%. Stocks will correct all the time, and occasionally a broad market correction will take place as well. Recently, we saw this take place with the S&P 500. In 2017, the stock market virtually went up in a straight line. This trend continued into 2018 until a correction took place at the end of January. The S&P 500 corrected from close to $2,900 to $2,580 in February. This was a correction of 11%, which indicated that the market was blowing off steam after an unsustainable run.
A bear market is a less frequent occurrence. Over the last 100 years, we have seen a bear market on average every 3.5 years. A bear market is a drop of around 20%, and a full recovery typically takes place within 15 months. The last bear market we saw was from October 2007 to March of 2009, but this was actually what I and most would call a stock market crash.
A stock market crash is a very infrequent occurrence, happening about every 10 years. This is a massive correction taking place that far exceeds the 20% that marks a bear market. A crash is a drop of 40% or more. For example, the bear market of 2007 to 2009 resulted in a 54% drop in the Dow Jones Industrial Average. Before that, the last stock market crash took place in the early 2000s during the dot com bubble. A stock market crash is the result of unusual circumstances when a bubble has formed.
What Is A Bubble?
A bubble forms when herds of people begin to invest in a particular asset. As more people invest, the market value, or what people are willing to pay, drifts further and further away from the intrinsic value, or the actual underlying value of the asset.
Eventually, the price gets so out of control that people are no longer wiling to pay it, and the buying pressure tapers off. As the price tapers off, people begin to sell and the price starts falling. This is far more common with individual assets, but entire markets can become a bubble. For example, the dot com bubble in the early 2000's and the housing bubble a few years later.
The most recent example of this is the cryptocurrency bubble that formed in 2017. Bitcoin, the most popular cryptocurrency, went mainstream. In January of 2017, each Bitcoin was worth around $1,000. As the year continued, the price climbed higher and higher. At the end of this Bitcoin mania, each digital coin was trading for just over $19,000 in December of 2017. This massive run up indicated a speculative bubble had formed, as this level of appreciation is not common with any assets. People were excited over this new currency, but this excitement led to hysteria. The bubble burst at the end of 2017, and by February of 2018 each Bitcoin was worth just under $7,000. This was a drop of over 60%, which indicates that this was a crash. A market crash occurs as a result of unusual circumstances. In this case, it was millions of people herding into a digital currency.
From this point forward, we will be referring to both a crash and a bear market as a crash, but do remember the difference. As we have discussed, corrections and bear markets are regular occurrences resulting from normal circumstances. Crashes on the other hand, are irregular occurrences resulting from irregular circumstances or the formation of bubbles.
What To Do Before A Crash
If you believe that a market is becoming overvalued and you want to take some precautionary steps, here are a few that you could follow:
- Simplify your portfolio. If you are holding individual stocks, consider what stocks you are investing in. Are you holding durable consumer staples stocks? Or volatile biotechnology stocks? If there is ever a time to invest in these high risk stocks, it is not when markets are at or nearing all time highs.
- Increase your cash reserve. One of the best things you can do before a crash is to increase your cash on the sidelines. Stock market crashes result in one in a lifetime opportunities, and those with cash are able to jump on them. If you are fully invested in the market, you are completely immobilized in the event of a crash. Your only option is to ride it out.
- Write down why you own what you own. You will want to have a clear idea of what you have in your portfolio and why you have it there. During a crash, emotions get involved and people will often make compulsive decisions. You should hold on to this written reminder in case you are tempted to take some kind of action.
- Diversify. One of the best ways you can minimize risk is through adequate diversification. A good rule of thumb to follow is to never have more than 20% of your money in any one thing. If you do, you are probably too heavily invested in that asset.
- Allocate more money into bonds or precious metals. During times of uncertainty, many investors will flee to other investments like bonds and precious metals. Gold has proven to be a suitable investment for outpacing inflation. On top of that, gold tends to hold up well in the event of a stock market crash as more money is being directed toward this asset.
- Go for a walk. Seriously! It is easy to drive yourself crazy worrying about your money and your investment portfolio. You want to make sure that you are keeping your emotions under control as to not make an impulsive decision. You can take steps to prepare for a crash, but beyond that you cannot control it. If you cannot control it, there is no reason to worry about it!
What To Do During A Crash
If you believe you are currently invested in a market that is experiencing a crash, here are a few things you could consider doing:
- Nothing. As mentioned already, one of the best things you can do during a market crash is to do nothing. Others around you will be generating a flurry of activity, and many will be making the fatal mistake of selling. Remember, it is not a loss until you recognize it! If you took steps to prepare for the crash and you are diversified across different assets, there is nothing for you to do.
- Be patient. If you are planning on taking advantage of the sale and scooping up stocks, do not rush! During a bear market, there are often a number of false bottoms that will continue to be breached as the market falls. At this point, the market is a falling knife! Wait for clear signs of a bottom or follow some of the bear market investing strategies we will discuss shortly.
- Write out a plan. Do not just randomly start buying stocks left and right. If you are planning on buying, consider what stocks you are looking to buy. Are you going to look for battered blue chips? Small cap stocks? You need to write out a clear action plan outlining what stocks you are looking to buy and at what price you are willing to pay. Failing to plan is planning to fail!
- Educate yourself. This can be a perfect opportunity to educate yourself on the stock market and what is going on around you. Before you make any decision, do your due diligence. You might want to consider having a discussion with a financial expert before taking any action in a bear market.
- Study the charts. While it is impossible to time the markets and identify the bottom, you can make an educated guess. By studying candlestick charts and learning about support and resistance areas, you can identify when a stock is testing a support. If it breaks down below the support, you know the stock is likely still in free fall.
What To Do After A Crash
If you believe the stock market has crashed and you are ready to take advantage of the opportunities, here are a few steps you could follow:
- Dollar cost average. This is one of the best ways to enter the stock market, especially in a bear market. As we mentioned earlier, a number of false bottoms often appear during a bear market. If you drop all of your money in at one, and the bottom is yanked out from under you, you are in a free fall. By dollar cost averaging, you are accumulating shares over time and paying the market average for these shares. In a bear market, this is likely going to be averaging down or lowering your average cost basis. Let's say you wanted to invest $10,000 in a S&P 500 index fund at the bottom of the market. Instead of dumping $10,000 in at once, you could invest $1,000 per month over 10 months to dollar cost average.
- Blue chip and AAA rated. Another strategy you could follow is to only invest in durable companies with an excellent debt rating. Companies often raise capital by issuing debt obligations known as corporate bonds. These bonds are rated by agencies like Moody's and Standard & Poor's for credit worthiness. The highest rating a company can receive is a AAA rating. This company has a high degree of credit worthiness and the lowest risk of defaulting on these obligations. The problem is, increased corporate borrowing has significantly reduced the number of companies with this prestigious AAA rating. In fact, there are only two. First, Johnson & Johnson. Second, Microsoft. You might need to lower your standards to a AA+ or AA for a broader selection. Another option is to invest in what is referred to as blue chip stocks. These are durable companies that have stood the test of time. While there is no official list of blue chip stocks, most people refer to the Dow Jones Industrial Average.
- Hunt for dividends. During a bear market, it is not uncommon to find a great company paying out a 10% dividend yield. It is important to understand that you should not simply look for stocks with high dividends! A dividend is never guaranteed, and a company could cut or cancel a dividend at any time. What you want to look at instead is the dividend growth streak. This is an indication of how long this company has been increasing the dividend payment. If a company has a 20+ year growth streak, they will do anything they can to continue paying that dividend. One of my favorite resources for researching dividends is Simply Safe Dividends. In this article, over 20 high dividend stocks are analyzed. For example, consider AT&T. This company has a dividend growth streak of over 30 years! It is possible that they could cut the dividend, but based on the growth streak and consistent operating history it is highly unlikely.
While you may be tempted to simply invest in the companies that have been hit the hardest, this might not be the best strategy. During each bear market, massive companies that were once considered institutions have gone bankrupt. This includes:
- Lehman Brothers in 2008
- Washington Mutual in 2008
- General Motors in 2009
- Pacific Gas & Electric 2001
- Texaco 1987
These were massive companies that appeared to be safe, but this was not the case. If a company ends up going bankrupt, you are one of the last people to get paid as a shareholder. You will likely see nothing. Keep in mind, one of the best things you can do during a stock market crash is to do nothing at all. While you can take some precautionary steps to plan for a correction, you can never know for sure when it will take place.