This alone – such a disconnect between stocks and what’s happening in the real world – has convinced many investors that another stock market crash is inevitable. But is it? Absolutely. There is no doubt that we will again witness a new stock market crash. Let’s talk about how you can prepare.
The most important thing to know
We don’t know when the next stock market crash will take place. While this may seem inevitable, we just don’t know. The past 10 weeks are a great example of how it is almost impossible to predict market crashes.
Think of it this way: On March 23, 3.3 million people had recently applied for unemployment as part of the foreclosure efforts. At the time, 31,000 Americans were diagnosed with COVID-19 and about 400 died. On this date, the S&P 500 has bottomed out, down about 34% from the February 20 peak.
Fast forward to today, and there are nearly 1.8 million confirmed cases of COVID-19, more than 104,000 Americans have died and millions more are unemployed as unemployment rises skyrocketing to almost 15%. However, the market is 37% higher than 10 weeks ago.
It’s a reminder that in the short term, calling up – or down – with stocks is pure luck.
The biggest mistake to avoid
Which brings us to the mistake to avoid: selling stocks to try to plan the next stock market crash. Today there are millions of people on the margins who sold in late March or early April, convinced that things would get worse before they got better. Instead, they have missed the massive – inexplicable – rally in the stock market since the trough of late March.
The trick with actions is to remember there are no tricks. The shares are the property of companies. Many are struck by the impact of COVID-19; some will not survive. But the best companies will get by and return to growth as the world overcomes this crisis. The hard part is to overcome the slowdowns so that you can enjoy the return to normal.
The stocks are incredible long term sources of wealth creation. This is true even if you buy at what seems like the worst possible time. For example, if you invested in an S&P 500 index fund like the SPDR S&P 500 ETF Trust in early October 2007, the next two years would have been terrible.
But even for people who bought at the height of the previous crash, stocks have made wonderful gains. Even between the peak before the Great Recession and the trough of the coronavirus crash this year, stocks outperformed bonds, like the Vanguard Total Bond Market ETF (NASDAQ: BND):
Equities have a long history of outperforming the “security” of bonds over long periods of time, even from the “worst” time to buy before the previous crash, to the “worst” time to sell at the lowest of the market.
The first action to take with your long-term investments is no action. The chances are much greater that you will profit if you leave your actions alone and let the power of owning big companies for many years pay off.
Selling that you’re “going out” before the next crash has certainly proven wrong for many investors this year. History clearly shows: time in the market works; Timetable the market does not.
Actions you can take to be ready for the next crash
So what can you do to be ready for the next crash? Make sure you have cash for three important but separate things:
- Unforeseen expenses
- Planned spending
- Invest to take advantage of the next crash
Create an emergency fund
Recessions, job losses, illness, natural disasters and a litany of other things can happen unexpectedly. In addition to having the appropriate types and amounts of insurance, you should aim to have cash savings that can cover six months or more of basic living expenses.
Your need for this money may arise with or without a stock market crash; having an emergency fund means you won’t have to sell stocks to cover unexpected expenses exactly when you should buy.
Protect the assets you will need soon
While your emergency savings are preparing for unexpected short term needs you should also prepare your wallet for those expected needs coming soon.
For this reason, it’s a good idea to start shifting some of your investment from stocks to high-quality bonds and cash several years before retirement, to send a child to college, or whatever. for which you are investing. The goal is to have a few years of spending on these low-volatility assets before you need them.
Of course, bonds and cash pay nothing for what you can get from dividend paying stocks, and you will miss the upside outlook for stocks. But at this point in your financial journey, your goal should be to limit the disadvantage unexpected money losses you can count on in the next few years.
Save money to invest in the next crash
We have already discussed the risk of moving too much from your cash portfolio. Can you imagine having invested a lot in cash at the end of March (maybe you can) just to watch the stocks soar? If it’s you, it’s probably going to be really difficult to return to stock at this stage. But history clearly shows that it is a big mistake to play the short-term guessing game to miss the winning long-term buying and holding strategy.
That said, a useful strategy is to keep a small portion of your portfolio – say, about 5% – that would normally be invested in stocks, and keep it in cash to invest when the market drops quickly.
Here is the plan I use with the money in my wallet:
- When stocks fall 10% from a recent high, I invest half the money in my portfolio.
- When stocks fall 20% from a recent high, I invest half of the remaining cash.
- When stocks fall 30%, I invest the remaining money.
Why these levels? In short, because we see a drop of about 10% once a year or two and a drop of about 20% once every five to seven years; a 30% drop has only occurred six times in the past 70 years. Holding cash for larger declines is a losing move as the market has always recovered much more than it lost before falling 30% or more. Of course, we may see another 30% drop in the next year or less; is that history says that it is not a worthwhile probability to bet on the farm.
A winning strategy for today and tomorrow
The above plan can help you avoid the following wealth-destroying actions:
- Make the unforced error of selling stocks just because the market is collapsing and missing out on the recovery by sitting in cash.
- Engage the strength mistake of having to sell in a crash because you need money now.
- Keep too much money on the sidelines for the next crash and hurt your long-term returns.
If you’re sitting on a ton of cash counting on another big crash coming up soon, look at history as a guide. Stocks could fall again soon, or it could take years – and a lot of gains – before the next big drop. On the other side of the coin, if you are as well exposed to stocks with assets that you will need to cash in over the next few years to cover certain financial needs, it may be time to sell some of your assets and get your asset allocation in order.
Either way, if you don’t have a firm plan in place that covers your short and long-term goals and needs, it’s time to put it in place and start acting on it. You will be in much better shape during the next stock market crash, whether this year or in several years.