There’s been quite a lot of negativity and pessimism lately.
There are countless articles from analysts who claim to know that the next market crash is upon us. The world “bubble” is thrown around on Twitter (TWTR) and across financial media. They did not see the 35% decline coming, nor the subsequent 40% recovery. Yet, they want you to believe that they have insights on what happens next and claim that it’s 1999 again.
The Nasdaq (QQQ) recently hit a fresh all-time-high as COVID-19 cases continued to rise in the United States. As a result, the bears are out in full force, arguing that there is no safe place to hide, or claiming that it will “all end up in tears.”
This idea that investing in stocks always ends poorly is such a baffling concept when you consider the outstanding returns generated by the stock market over more than 150 years. Those who are solely focused on when the music might stop are the ones that will likely miss the party altogether.
The truth is, nobody knows where the market is headed next. I recommend you run away from any charlatan who tells you otherwise.
Volatility is a natural part of investing. Not only should you accept it, but you should also embrace it. The possibility of a market crash should not be a reason to change your strategy, because your strategy should be built assuming market crashes will occur, to begin with.
Today, I want to cover the ways you can prepare for the next stock market crash, be it in a day, a week, a month or a decade. And I don’t mean to discuss all-weather portfolios or diversification. The point of this article is not to make sure you avoid the next market crash by timing the market or barricading your portfolio against volatility. Instead, I want to discuss the ways you can protect your portfolio from yourself.
You see, the principal risks your portfolio is exposed to are your own mistakes. If you focus on having the right mindset, you’ll have the odds in your favor when the inevitable challenge comes your way.
Let’s review the five ways you can prepare yourself to successfully maneuver the next market crash and come out of it unscathed.
1) Ask yourself how much drawdown you can cope with
The stock market, using for reference the Standard & Poor’s 500 index (SPY), has delivered approximately 10% return annually on average from 1926 to 2018. But to enjoy the benefit of such outstanding returns over time, investors had to cope with both good and bad years.
You can see below the yearly returns of the S&P 500. Performance can be all over the place in the short term and is rarely at the 10% average.
Those who try to time the market to avoid a red year can easily jeopardize their long-term performance simply by being out of the market at the wrong time. Even missing a few good days out of an entire decade can annihilate most of your returns.
Fidelity crunched the numbers on what would happen to a hypothetical $10,000 investment into an S&P 500 index fund from 1980 to 2018 if you missed a few of the best days:
- By missing the five best days, your returns would shrink by 35%.
- By missing the fifty best days, your returns would shrink by 91%.
The data is clear that there is no point in trying to avoid a bad year when the opportunity cost of missing a good one is likely to be a lot more damaging to your performance over the long term.
Alas, many investors choose to ignore the data and constantly try to anticipate the next market correction. To do so, they treat the market like a swimming pool on a nice summer afternoon. They come in and out based on how they feel. They choose to act based on the most recent news and ignore common sense.
The reason why most individual investors underperform the market averages is because they are out of the market at the worst possible times. The solution is extremely simple. Stay invested as long as you possibly can!
But it’s easier said than done when you consider the drawdown investors had to cope with over the years. As pointed out before by Morgan Housel, partner at The Collaborative Fund, stock market crashes happen all the time.
Recognizing how often market crashes happen can give you a better idea of what you are getting into and the risks you are taking when investing in equities. Here is the historical frequency of pullbacks identified since 1928:
|Market drawdown||Historical Frequency|
|10%||Every 11 months|
|15%||Every 24 months|
|20%||Every four years|
|40%||Every few decades|
|50%||2-3 times per century|
According to a research note from Bank of America Securities, the average time for the market to get back to where it was after a drawdown of 20% or more is 4.4 years. This is why most advisors recommend to invest in equities only if you intend to hold your investment for the next five years. Even assuming you have a terrible timing and invest right before a bear market, you will still have a good chance to be back in the green after five years.
Understanding market crashes and being prepared psychologically to have to go through them without overreacting is possibly the most fundamental part of learning how to invest.
If you fully understand that 1) there is no point in timing the market, since it can do more harm than good, and 2) market crashes will occur and there is nothing you can do about it, you can start getting comfortable.
With the right mindset, there is no amount of negativity or bearishness on Wall Street and in the financial media that can disrupt your strategy. When you read a headline that states that “a 30% market crash is coming,” your only reaction should be to ask: “So what?” It always has been, it always will be.
Part of preparing yourself psychologically for market crashes is to understand your tolerance to volatility. How much drawdown is too much drawdown? How much lower can your portfolio get before you would call it quits?
If staying the course is the name of the game, defining and recognizing your tipping point is a requirement to define your exposure to equities and expose your financial assets to the right amount of volatility.
The longer your time horizon is, the less market crashes matter. That’s why people that are still building up their nest egg and are more than a decade away from retirement will have a different tolerance to volatility than someone already retired and relying exclusively on their financial assets to generate income.
Morningstar has built a market crash timeline showing the growth of $1 invested in the US market over 150 years. They are using a logarithmic scale to be able to fit all large market sell-offs in one graph. The view of all market crashes since 1870 gives a sobering, but also very optimistic view of what to expect over the years if you remain invested through thick and thin.
No matter how bad the crashes have been, the market has always rebounded. It continues to expand to new highs, following closely GDP growth.
Of course, hindsight is 20/20. You would have had a hard time convincing those who were going through the 79% market drawdown in the crash of 1929 to believe the market would eventually rebound. Many investors who have been through the “lost decade,” with two major crashes of more than 40% back to back in the 2000s, have been disillusioned and probably quit on the market right before it was about to have one of its best decades ever.
Once you know how much drawdown you can cope with, you can decide what portion of your portfolio should be exposed to equities without living in fear of the next market crash.
To quote Alfred Wainwright:
There is no such thing as bad weather, only unsuitable clothing.
If your portfolio suits your goal and you know what to expect, no storm can get in your way.
2) Make sure you have the cash you need
Investing money you will eventually need to withdraw from the market in the near future can lead to a permanent loss of capital. Cash has an extremely important role in the way your can prepare yourself for a market crash. Personal finance 101 always starts with:
- Paying off short-term debt.
- Building an emergency fund.
The emergency fund is a personal budget set aside that you can use in case of, well, emergency. Whatever life throws your way, your emergency fund should be able to cover it. Loss of income, accident, home repair, medical emergency, last minute travel expense, you name it. It usually represents 3 to 6 months of expenses for people who are employed. It can become much bigger as you get closer to retirement based on your personal circumstances and the peace of mind you are seeking. By definition, you never know when you’ll need to access your emergency fund. For that reason, it should not be invested in equities.
If you have built an emergency fund and are ready to invest, the next question should always be the same:
Will you need the money you’re investing today in the next five years?
- If the answer is yes, the money probably shouldn’t be invested in stocks.
- If the answer is no, a large equity exposure makes sense.
On a rolling basis, your time horizon should always prompt you to adjust your equity exposure. Do you have a big down payment for a house coming up in the next five years? You should start withdrawing the corresponding funds while the market is doing well to avoid doing it at the worst possible time later on.
Many investors lose money in a market crash because they need the money and have no other choice. Whether it is paying for college for their kids or paying off their mortgage, investors end up stuck between a rock and a hard place.
Retirees who regularly withdraw from their investment accounts should have a plan to do so from the least volatile part of their financial assets during a market crash. If the money they need in the next five years isn’t invested in equities, this shouldn’t be a problem.
The next place where you might want to built your cash reserve is your investing fund. Do you have cash readily available to take advantage of a market sell-off? The level of cash allocation in your portfolio (that is, on top of your emergency fund) should be aligned with your own risk profile. In the face of a market crash, investors have the pernicious habit of selling positions in order to “raise cash” to invest in other stocks that have fallen. They may not realize this, but raising cash during a market crash is, in fact, panic selling. A market crash is the last moment you should be selling stocks, even if you think you are outsmarting the market. Yet, that’s what we are hardwired to do as human beings. We sell when stocks are down 25% because we believe they are going to be down 50% soon. We convince ourselves that we are being smart about it and re-allocate funds to take advantage of the short-term volatility. It’s usually the way investors lose their shirts.
If you don’t want to feel tempted to try to raise cash at the worst possible time, you should have part of your investing portfolio sitting in cash. What that allocation is comes down to your risk profile, time horizon, and how well you sleep at night. Maybe that number is 3%, 5%, 10% or even 25% of your portfolio. An important thing to keep in mind is that the higher your cash allocation, the more you may adversely impact your long-term returns. After all, if you are 100% in cash, your returns are guaranteed to be zero.
There are no wrong answers. Only answers that are right for the kind of investor you are and your own temperament. The goal here is to have the tools that are best for you to succeed.
If you are still employed and regularly add money to your portfolio via fresh savings, I often make the case that the cash allocation you need in your investment portfolio is probably very close to zero at any given time. But again, it comes down to knowing yourself and whether or not you need a cushion to feel at ease during the most challenging times.
3) Build a portfolio that suits your risk profile
If you have defined the kind of drawdown you can cope with, you can confidently build a portfolio with the right equity exposure. If you can’t stomach the idea of a 20% sell-off in your portfolio – even temporarily – you probably don’t want more than half of your financial assets exposed to equities.
The type of equities you invest in is also a fundamental part of the equation. Suitability is one of the most overlooked aspects of a portfolio strategy.
There are three risks to consider when it comes to suitability:
- Risk appetite: the level of risk you are prepared to accept.
- Risk tolerance: the level of risk you can handle.
- Risk capacity: the level of risk you can afford to take.
If your risk appetite is higher than your risk tolerance, you might end up biting more than you can chew. Even assuming you can stomach it, you might be putting your family at risk if you go beyond your risk capacity (e.g. options trading while barely being able to pay rent).
When you look at your portfolio today, ask yourself what you would do if all positions went down 50%:
- Would you suddenly want to change your asset allocation?
- Would you have a change of heart on specific positions?
- Would your life be impacted in any way in the short term?
If the idea of a stock falling by 50% overnight is horrifying to you, maybe you want to hold off on that small biotech investment opportunity you heard about. Meanwhile, if you have decades ahead of you before retirement and save more in a year than the value of your entire portfolio, you can probably take some risks and allocate funds to “moonshot” opportunities that could create tremendous alpha for your portfolio if the stars align. At the end of the day, your portfolio should be tailor-made for your own goals and risk tolerance and nobody else’s.
Since Marc Andreessen published his essay about Why Software Is Eating The World in 2011, SaaS companies have been some of the very best-performing public equities. Companies like Salesforce (CRM), Atlassian (TEAM) or ServiceNow (NOW) have turned into incredibly successful businesses in the past decade. But for some investors, the idea of investing in a company that is not yet profitable is unbearable. And that’s okay. If you are not fully on board with the bullish thesis behind an investment, chances are that you will bail as soon as the stock loses its momentum. In turn, this would likely create enough damage to your portfolio to offset any successes you had elsewhere.
Another great example is Tesla (TSLA), one of the most polarizing companies on the planet. Rarely can you find bulls and bears disagree so intensely about a company. If this is too much of a roller-coaster for you to handle, then this stock should not be part of your portfolio.
Warren Buffett is famously known for having avoided technology stocks for many years because he didn’t believe he had an edge in this category. He didn’t invest in FANG stocks (Facebook (FB), Amazon (AMZN), Netflix (NFLX), Alphabet (GOOG) (GOOGL)) for years on end, despite their compelling long-term potential. He eventually made Apple (AAPL) his biggest holding and now owns Amazon shares. He has also invested almost exclusively in American companies throughout his career, and it has worked beautifully for him. Nobody should ever make you feel like there is a right way and a wrong way to invest. It comes down to the way you are handling it over time and your capacity to stay the course.
There are clear warning signs that should make you question your existing approach. For example, if you find yourself checking your portfolio or the movements of a specific stock you own several times a day, you may be taking more risk than you can tolerate. Have you ever lost sleep because of an investment? The answer should be a resounding no! Investing is an incredible tool to achieve financial independence and reach your goals. But you shouldn’t have to suffer through the process. A key component of the success of your investing journey is your capacity to stick with it for decades on end. It’s a marathon, not a sprint.
Investing is a lot like eating, sleeping or working out. If you put the effort into understanding how to do it right and what suits you best, chances are you will do extremely well over time. But you have to know your limits and recognize your strengths and weaknesses. We all have specific circumstances and there is no such thing as a one-size-fits-all portfolio.
4) Build a wish list of stocks to buy on sale
The best-of-breed companies rarely go on sale. But when they do, it’s time to pounce. Broad market sell-offs are the perfect opportunity to accumulate shares of the best companies the market has to offer.
But here’s the real challenge. Investors might repeat to themselves that they wish they had bought Amazon when it was trading under $1,500 or that if only Netflix dropped 30% they would buy it in a heartbeat. The reality is that when the opportunity presents itself, they start changing their expectations and the price is never low enough to pull the trigger. They think “it’s not the bottom yet,” or they assume “it can always go lower.”
By building a wish list of the best-of-breed companies you wish you owned and at what price, you can make sure you’ll be clear-headed when the time finally comes. You’ll feel encouraged to buy because you’ll recognize that your past self would have instantly bought these shares at their current price, and only your emotions are preventing your present self to do so.
Only with a wish list built when you are at ease will you make the right choice in the heat of the moment.
Have you ever gone grocery shopping while hungry? I certainly have. It can lead to poor decisions. By the time you get home, you realize that you bought junk food you don’t need or that you ended up choosing exclusively things you were craving in the moment.
The very same reaction occurs in the midst of a market crash. Without a wish list pre-emptively built, you might end up buying stocks that you shouldn’t own in the first place, just because they have fallen even more than others. The problem with this is that stocks that fall the most in a market crash are not necessarily the best ones to buy. There could be profound secular changes happening that more than justify the sell-off for some industries or categories.
Just recently, through the COVID-19 pandemic, airlines have been in an extremely difficult spot. Before the global pandemic, business travel made up 60% to 70% of sales for US airlines. Those days could be over for good as secular changes occur in the way we collaborate via video conference. Warren Buffett was not buying more shares of United (UAL), American (AAL), Southwest (LUV) or Delta Air Lines (DAL) in the past few months. He was selling them all based on their radically challenged long-term prospects.
In June, Hertz (HTZ) – a company that had filed for bankruptcy – saw a buying surge. Let’s be clear. There is no way a company like Hertz would make it to your wish list pre-COVID. Your homework prior to a crisis can keep you away from poor judgment when everything is on sale. It can be tempting to see some stocks as the deal of a lifetime when they have dramatically dropped. The stocks you are likely to get the most excited about in a market crash will rarely be the ones you should be focusing on. Building your wish list when you are calm and collected is the ultimate antidote.
5) Write down your strategy
In his book The Money Game, Adam Smith explained:
If you don’t know who you are, [the stock market] is an expensive place to find out.
Despite our best intentions, we can still fail. That’s true of most things in life. Being married or parenting are perfect examples. No matter how clear our intentions are, many of us can fail right when it matters the most to have everything under control. Investing is no different.
I covered before how your temperament is the single greatest factor in your portfolio’s returns. There are many ways to fight our natural flaws and avoid the pitfalls we can easily fall for. When it comes to preparing yourself to handle a market crash, I believe the most powerful tool is journaling.
In investing, journaling is the closest thing you’ll ever have to a drill. While NBA players can shoot free throws all day long, the only way you can practice your readiness for a market crash is by writing down and repeating to yourself what your long-term strategy is.
- Why do you invest?
- What is your time horizon?
- What’s your investment philosophy?
- What will you do if the market falls significantly and your portfolio along with it?
These are not questions you want to answer in the middle of a market crash.
Right when everything is falling apart, without being able to read your calm self, you might be left alone with your panicked self. Success comes with homework and preparation. The more you set yourself up with the right mindset ingrained in your brain, the higher your chance to avert a crisis in the heat of the moment.
Market crashes are not something you should fear. They are unavoidable and a necessary trade off to benefit from the outstanding returns public equities can deliver over the years.
By knowing your stock market history and defining how much drawdown you can cope with, making sure you have enough cash on hand, building a portfolio in line with your risk profile, maintaining a wish list of best-of-breed businesses you hope to buy in a market sell-off and writing down your strategy, you will be immensely better equipped to go through the next market crash. And most of all, you will empower yourself to be a true investor focused on the long term, unshaken by the vicissitudes of the market in the short term.
Going through the challenges the market will be throwing at you is likely to be an extremely rewarding experience if you stick around. It might not always be easy, but the journey will be well worth it.
How about you? What are some ways you prepare for inevitable market crashes? How do you make sure that you buy and sell based on your investment principles and not your emotions? Let me know in the comments!
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Disclosure: I am/we are long AAPL AMZN CRM FB GOOG NFLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Originally published on Seeking Alpha