SStock market crashes can be frightening because they can happen at any time without warning. They can also lead to huge losses in your investment portfolio in a very short period of time.
But they are normal, inevitable and cannot be avoided. Instead of worrying, you can prepare for one by doing these three things.
Image source: Getty Images.
1. Make sure you don’t take too many risks
A stock market crash could cause your portfolio balance to drop. But How? ‘Or’ What you are invested could determine how much it drops. Your asset allocation model is the percentage of stocks you have over bonds. Stocks are considered riskier than bonds, so the more of them in your mix, the more you could lose.
If you’re feeling nervous about a crash, adding more secure investments to your accounts might help cut losses. But the trade-off of reducing your risk is a big blow to your return. And this type of movement will also result in a lower percentage gain on average and during years when the stock market is performing positively.
And as tempting as it may be to lower your risk during a bear market and increase it during a bull market, it’s the timing of the market, which is incredibly difficult. If you are wrong, you could reduce your exposure to equities too soon or increase it too late, resulting in lower returns. That’s why your best bet may be to find an asset allocation model that you feel happy with throughout all market cycles.
The table below shows how different asset allocation models would have worked on average during the Great Recession in 2008 as well as the following year when the stock market recovered.
| Asset allocation | Average rate of return | 2008 Losses | Profits for 2009 |
|---|---|---|---|
| 100% shares | 10.3% | (37%) | 26.5% |
| 60% equities, 40% bonds | 9.1% | (20.1%) | 18.3% |
| 40% equities, 60% bonds | 8.2% | (1.7%) | 14.2% |
| 100% bonds | 6.1% | 5.2% | 5.9% |
Data source: calculations by author.
2. Think long term
What are you using your money for? Watching your account balance drop significantly is never easy, but it could be more devastating depending on how quickly you need the cash. If you’re saving for something like your child’s education in five years, a 40% loss could mean you can’t afford the tuition. But if it’s for something like your retirement in 20 years, the threat isn’t so imminent and you’ll likely have time to recoup your losses.
It is for this reason that you should always consider your time horizon when investing. The more time you have until you need the cash, the more aggressive your holdings can be, and the shorter the period, the more careful they should be. And the money you need over the next couple of years must be completely excluded from the market.
For example, a $ 100,000 investment in large-cap stocks would have lost 43% of its value during the dot-com crash in the early 2000s, and would have been reduced to $ 57,000 by the end of 2002. It would not have returned to its original value for five years. But at the end of 2020, 18 years later, it would be worth 354% more, despite an additional loss of 37% in 2008. This is illustrated in the table below.
| Investment in 2002 | 5 years later | 10 years later | 15 years later | 18 years later |
|---|---|---|---|---|
| $ 57,000 | $ 104,000 | $ 113,000 | $ 235,000 | $ 354,000 |
Data source: calculations by author.
3. Diversify your holdings
Adding different asset classes like bonds to an all-equity portfolio is one way to diversify your holdings. But you can also reduce your risk by adding different types of stocks or sectors. The stock market as a whole may suffer during a crash, but depending on the reason for the crash, certain industries may fare worse – such as tech stocks during the dot-com crash, real estate during the Great Recession and hotel values ​​during the 2020 coronavirus crisis.
It could be difficult to know which industries, if any, will do worse. As a result, you could do very well if you have a lot of money in a well-performing industry, but lose a lot if you invest most of your assets in a poorly performing industry.
That’s why owning a wide range of different types of businesses can help reduce the risk of concentration – or having too many eggs in one basket. The table below shows how the individual sectors performed in 2020 compared to what a mixed portfolio of the five would have done.
| Computer science | Health care | Financial | Immovable | Energy | Mixed yield | |
|---|---|---|---|---|---|---|
| Return rate | 43.6% | 13.3% | (1.7%) | (2.1%) | (32.5%) | 4.1% |
Data source: calculations by author.
You might fear a stock market crash, but those fears won’t stop one in the long run. Instead, you can better prepare yourself and your wallet to resist it. And while you can’t stop all the losses, you can find a level of loss that you feel comfortable with that won’t stop you from achieving your goals.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.