In this article, we will see how to react when the stock market crashes.
You’ve probably noticed that the stock market is very volatile.
When the market goes up, investors chase high-flying stocks but when the market goes down, people panic sell out of fear of losing their capital.
Is this the correct strategy?
You should never invest emotionally, and you should always try to remain rational.
In fact, what many beginner investors fail to understand is that stock market crashes are actually the best opportunity to initiate positions or reinforce positions they already have.
In other words, stock market crashes are actually the best time to buy stocks.
Here are 5 things you should do, or consider doing, when the market is crashing:
1. Stay Calm
No one likes to see their investments lose value.
It’s important to acknowledge the feelings of panic you feel as a result of seeing red in your portfolio.
The danger of acting out of fear is that you may decide to liquidate your positions in order to avoid losing everything.
This is a serious mistake!
Rather than acting on impulse, keep these 2 things in mind:
a. Focus on the big picture
The first thing you should do to avoid panic-selling is to look at the long-term chart of the products you are invested in.
When you zoom out, you will notice that the current drop in the market is probably quite insignificant.
For example, while market drops in the S&P 500 can occur once to twice a year, you will see that over a longer period of time very big drops in the stock market are quite rare. From 1926 to 2018, the S&P 500’s average annual return was 10% a year.
To benefit from this return, however, you need to have stayed invested during the entire year.
b. The best days come after the worst days
If you sell your positions when the market crashes, hoping to re-enter at the right time, chances are that you will miss the best days.
How is this possible?
Simply because the best days of the S&P 500 usually occur immediately after the worst days. In addition, it is almost impossible to accurately predict exactly when the crash will end.
Studies show that if you miss the best days of the S&P 500, your profitability will decline severely:
- If you missed the 5 best days between 1980 and 2018, your returns diminished by 35%
- If you missed the 50 best days between 1980 and 2018, your returns diminished by 91%
In other words, if you miss the 50 best days out of a 38-year period, your return will be 91% lower than someone who stayed invested during even the worse market crashes. The period between 1980 and 2018 included, among other smaller crises, the Dot-Com Crash and the Subprime Mortgage Crisis of 2007-2008.
As a general rule, you should avoid trying to time the market. Yes, stock markets are volatile, but they are also very resilient. Over the long term, the market trends upward; and while stock markets are made of busts and booms, bull markets tend to last much longer and generate more gains than bear markets generate losses.
The best thing you can do when the stock market crashes is not panic. Look at the big picture to remind yourself that bear markets are normal and that they will be followed by a market expansion.
2. Do Nothing
While this may seem counter-intuitive, it is closely related to the advice above, even as you see the value of your stocks plummet.
The reality is that stock market crashes are the worst possible time to re-balance your portfolio.
You are no doubt under much stress and unlikely to analyze the situation with a level head. In such situations, you may be tempted to sell your positions at a loss, trying to latch on to other stocks that appear to be faring better at the moment. Such a strategy can lead to subpar results and, ultimately, horrible returns.
Do this instead:
a. Stick to your strategy
It is very important to have an investment strategy before you start investing in the stock market.
Having an investment strategy means you have set your financial objectives, you have done your due diligence and thoroughly researched the assets you wish to buy in order to determine their quality.
If you have high quality stocks that are currently losing value, ask yourself: is the asset losing value because there is a broad market sell-off or there is a structural decline in the fundamentals of the company or the asset?
If the answer is the former (broad market sell-off), then you should not be concerned about the value of this asset. If it was quality before the crisis, it will remain high quality after the crisis, and the price will recover.
If the crisis impacts the fundamental structure or nature of the company, then you may want to consider selling. That is the only circumstance under which you should consider selling your asset during a stock market crash.
Otherwise, hold on to your assets. During a crash, your default assumption should be to hold on to your assets and weather the storm.
When in doubt, do nothing.
3. Buy the dip
If you have a predetermined investing strategy and you have cash on hand, a stock market crash is the perfect opportunity to buy high-quality stocks.
As Warren Buffet says, it is a good idea to “be fearful when others are greedy and greedy when others are fearful.”
When the stock market is flying and reaching all-time highs, you should be cautious about buying. However, when the stock market is crashing and everyone is selling, you can seize the opportunity to buy high quality stocks at a discount.
However, you don’t want to go and buy just any stocks that happen to be selling at a low price. Warren Buffet also says that it is “far better to buy a wonderful company at a fair price than a fair company at a wonderful price.“
a. Look for high quality stocks that are trading at a discount.
If you have cash on hand to invest, ask yourself these questions:
- are you buying a high quality company or a speculative asset?
- are you buying just because the price is cheap or because you can buy a high quality company at an incredible price?
The thing with speculative companies is that they are more likely to decrease in value during normal market conditions than are high quality companies.
b. Have a wish list
This is why, in addition to having a predetermined investment strategy, you should likewise have a running wish list of high-quality companies you are interested in. When the stock market crashes, target those companies that you have already researched and vetted. If the price is good, buy in.
Keep in mind that in the short term, the price of an asset is often de-correlated from the fundamentals of the company. This means that the price of a high quality company will decrease for no justifiable reason other than the market as a whole is experiencing a sell-off.
That is a perfect opportunity for you to buy the dip.
4. Inject your capital wisely
Let’s say you have a predetermined investment strategy, you have cash on hand to invest, and you have your wish list of high-quality stocks to buy at a discount.
a. Have a specific stock market crash investment strategy
Some people will suggest to invest all your money today in case the crash ends tomorrow and prices start to climb again. Others will suggest that you spread your investments over a period of time to capitalize on the various down days, lowering your average cost and putting you in a better position to profit when the market goes up again.
There is no easy answer. Both strategies have their advantages and their risks. If you inject all your money immediately, you run the risk of the crash running longer than expected; but if you spread your investment out over a period of time, you risk investing too conservatively and missing out on opportunities if the market picks up sooner than expected.
Just like it is important to have an investment strategy for when the market is normalized, so too is it important to have an investment strategy specific to when the market is crashing. Decide exactly how you will invest before the crash occurs. That way, when the crash happens, you do not need to panic because you have already decided how you will invest.
Everyone’s plan will look different depending on factors such as personal risk-aversion, investment strategies, and the amount of cash you have on hand to inject into your portfolio at the moment of the crash. Pick the strategy you are most comfortable with and stick to it when the moment comes.
Remember that the worst time to review and fine-tune your strategy is when the crisis hits. So consider all the factors before hand so you have a strategy to fall back on when the moment comes.
5. Re-balance and diversify your portfolio.
The stock market crashed, but you were prepared. You did not panic because you had a predetermined strategy to follow. Either you had cash on hand and invested in companies on your wish list that you saw were trading at a discount due to broad market-sells offs; or, you did not happen to have cash on hand, so you waited out the crash, at peace in the knowledge that the bear market would eventually end and the value of your portfolio would recover.
Now, the crash is over, and you decide it’s time to re-evaluate your portfolio. Maybe this crash revealed to you that your portfolio holds too many risky investments or that too much of your money is tied up in the stock market and you want more diversity in your portfolio.
Whatever the reason, the time to re-balance and diversify your portfolio is when the crash is over and equity prices start going up again.
a. Invest in various asset classes for optimal diversification.
An asset class is anything that can generate a return on your money. In addition to the stock market, here are the 6 main asset classes:
- Cash (invested or saved) is a low-risk investment, generating the lowest of all returns. Think of, for example, the abysmally low interest rates if you open a savings account at your local bank.
- Bonds (government or corporate), like cash, are low-risk investments. They allow you to receive a fixed interest rate that is negotiated in advance. While bond return rates are extremely low these says, bonds can still have a place in your portfolio if you want to have very low-risk investment.
- Commodities (ex: oil), though traded for in the financial market, can be treated as a separate asset class.
- Real estate is one of the most popular asset class in many areas of the world. Real estate is a very powerful way of generating wealth over a long period of time.
- Precious metals are another very popular asset class, and a great way to diversify a portfolio. In a way, gold and silver are not really investments, but rather universally recognized stores of value. If you buy gold, do not expect spectacular returns; rather, use gold to protect yourself against currency devaluation and inflation. In my opinion, gold is an asset that has a place in everyone’s portfolio.
- Cryptocurrency is a novel class that emerged roughly 10 years ago. Many people don’t understand the technology behind cryptocurrency and are uncomfortable investing in this asset class due to their inherent volatility. If you are interested in cryptocurrency, the best place to start is with Nitcoin. Bitcoin is one of the best performing assets of the past decade. In fact, some people say it’s the best performing asset in history. Given the fundamentals of cryptocurrency, we can expect that the price will continue appreciating in the future as institutional investment continues to increase.
If you hold some positions in all of these 6 different assets, you will have broad exposure in your portfolio that can help you offset the volatility of each individual asset class.
However, even if you feel overweight in stocks, it is a good idea to wait until the stock market crash is over before you re-evaluate your portfolio and diversify your positions.
When it comes to the stock market, we are all looking to have the best returns possible by saving and investing. While we all employ different strategies, we ultimately have the same goal: to make as much money and generate as much wealth as we can over the long term.
There are many obstacles that come our way, and these temporary hurdles can make people panic and rethink their strategies and objectives … at the worst possible times!
If you have a strategy that you established in advance, it is generally a bad idea to put it in question (or worse, completely change it) because of a broad stock market sell-off.
In the stock market, as in life, there is no miracle recipe or short-term path to success. Everything is a long-term game which requires patience, discipline, and self-sacrifice.
Therefore, if you take anything away from this article, it is this: establish a strategy and stick to it over the long-term. You can re-balance your portfolio every once in a while, but a stock market crash is not the time to do so.
Rather, a market crash is a better time to buy stocks.
- Stock markets are inherently volatile. It is not a question of if the stock market will crash, but rather when.
- If you can keep this in perspective, you will be less likely to panic when one occurs because you know that they will not last forever.
- Equipped with this knowledge, you can either do nothing and wait it out; or implement your predetermined strategies to buy (not sell!!) high quality stocks that are trading at a discount.
- When the crash is over and the market normalizes again, you can revisit and fine-tune your strategy, re-balance, or diversify your portfolio — if you want.
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DISCLAIMER: This article is the fruit of my personal research and should not be viewed as financial advice. I enjoy analyzing stocks and providing investment ideas but I highly encourage you to conduct your own research before investing in any asset. NEVER invest without having done proper due diligence and NEVER invest out of the Fear Of Missing Out (FOMO). Also, NEVER invest because some internet message boards are hyping up a high-flying stock. As a rule of thumb, the number of rockets included in a tweet are inversely proportional to the quality of the advice given.