What I Plan to Do When the Market Crashes

One of the most common questions financial TV hosts ask their guests is whether they expect a pullback or a crash to hit the market. It's an odd question, akin to asking whether they expect summer to occur. Of course summer will occur, and of course stocks will pull back. Since 1928, the S&P 500 (SNPINDEX: ^GSPC  ) has declined 10% or more from a recent high 89 times, or about once every 11 months, with just a handful of years escaping a 10% dip. Ten-percent pullbacks are almost as common as summers. Twenty-percent market drops have occurred 21 times since 1928, or about as often as presidential elections.

But investing is emotional and the allure of money makes us delusional, so we train ourselves to both think the market doesn't (or shouldn't) crash from time to time, and panic when it does. Few of us are immune to this, as the number of investors who claiming to be contrarians outnumber actual contrarians by orders of magnitude.

When you become resigned to the frequency of market crashes (and our tendency to panic when they hit), having an investment plan based on strict rules makes way more sense than flying by the seat of your pants and hoping you act rationally when everyone else doesn't. 

So I put together a plan to guide how I invest when the market crashes next.

Say I have $1,000 cash set aside to invest (in addition to an emergency fund). It's opportunistic money. Here's my roadmap for deploying it:

These rules apply to the portion of my portfolio that invests in broad-based stock index funds, since opportunities in specific companies and sectors vary in unpredictable ways during each crash.

Here's my thinking behind it.

I assume the larger the market drop, the bigger the opportunity to invest. I wanted to deploy enough money to take advantage of the "decent" opportunities while still having enough around for the "big" opportunities. The amount of cash deployed peaks when the market falls by 20% because that's both a large decline and a historically frequent decline. The market falling 50% represents the greatest opportunity, but it occurs infrequently enough that I don't want to earmark a ton of cash waiting for it to happen.

This is a rough guide. It doesn't take into account things like valuation. I'd likely ignore a 10% drop after a grossly overvalued market like we had in 2000. And it overlooks the fact that better opportunities may exist in bonds or real estate.

Will I follow this plan to a T? Probably not. But it got me thinking about volatility. Putting these numbers on paper forces you to think about big market drops as opportunities to exploit, rather than crises to fear. It's actually hard to think about these numbers and not want the market to crash. And most important, it provides a guide to consult when stocks do crater, based on a cool-headed analysis of history rather than an emotional reaction to the guy on TV telling me to panic.

Winston Churchill once said, "Let our advance worrying become advance thinking and planning." Wise advice to consider. 

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  • Report this Comment On August 19, 2013, at 1:10 PM, DS31 wrote:

    Morgan,

    Great exercise to think through but, in practical terms, these guidelines just push out the "problem of when to invest" to the next level of uncertainty. What I mean is this:

    You already have an emergency savings "bucket." Presumably, you also have other investable assets presently in the market according to your own asset allocation plan. Now you are faced with additional funds that you have saved that you want to commit to equities but you're looking for market pullbacks to trigger your timing decisions.

    Scenario 1: If we go through, for instance, a 5 year stretch where the market never declines by 10% (unlikely, I know), then your additional funds never get invested and, very likely, they continue to grow as your savings continue.

    Scenario 2: If we go through a 5 year period where the market only experiences 1 or 2 "10% corrections" but never declines further, then you've only invested 10-20% of your investable savings which, again, very likely continue to grow (I'm assuming good savings habits and folks spending within their means and keeping debt to a minimum).

    Scenario 3: We get a decline in the market that approaches a 30% threshold at least once during this 5 year period and so we're able to get about 60% of the savings invested.

    Scenario 4: We have a 50% or greater decline and we finally get all funds invested, but this is not very likely to occur within any given 5 year period.

    So the problem remains of what to do with one's accumulated savings while waiting for opportune times to invest. CD's and Savings Accounts are not reasonable "parking spaces." I'm of the opinion that if I already have other investments and I already have sufficient emergency savings, AND I expect to continue saving even more additional funds from my income, then I should invest nearly all of those savings throughout any given 5 year period of time. That allows me to save up while the market sits at higher valuations and to invest nearly all of those funds throughout any 5 year period of time. But this more nebulous process still is difficult to employ and still requires controlling one's emotions as you rightly point out.

    Thoughts?

    Dan

  • Report this Comment On August 19, 2013, at 1:40 PM, MaxTheTerrible wrote:

    Morgan, you mentioned that you may disregard some big% drops given the market is overvalued, which makes me wonder how many of those big drops came on the heels of significant overvaluation... And wouldn't taking those specific events out make the rest significantly less frequent?

  • Report this Comment On August 19, 2013, at 2:03 PM, nberube wrote:

    Personally, I simply add money every month to my index funds. If the market is down, good, more stocks for me. In 30 years no one will care about that wild 10% swing back in 2015.

  • Report this Comment On August 19, 2013, at 2:09 PM, mikecart1 wrote:

    nberube,

    You have the right idea. Not necessarily about the index funds but the idea of ABA - Always Be Adding. By doing that you are ahead of 99.999% of the game. Many people try to time the market, others panick, others get too emotional. If you are always adding to your investments, you have no emotion and panicking goes out the window. By always adding, you also could care less about timing.

    Cheers!

  • Report this Comment On August 19, 2013, at 2:12 PM, TMFHousel wrote:

    I, too, add to my stock investments every month. But I also have cash set aside to deploy during big crashes.

  • Report this Comment On August 19, 2013, at 2:22 PM, alexf wrote:

    I too add periodically. Every month in my (small) 401K at work automatically, once or twice a year to my IRA to max the yearly contribution limit, and also add often (every quarter or so) to my brokerage account at a discount broker where I keep my riskier stuff and the only account I ever take money out from when needed (i.e. *very* rarely). The money grows. If the market falls, I see a buying opportunity.

    Fool on!

  • Report this Comment On August 19, 2013, at 3:36 PM, hbofbyu wrote:

    For the sake of clarity, if the market were to crash 20% in one day, would you purchase $300 of stock or $620? Or if it were to fall 10% each quarter over a year would you purchase at each 10% drop (total $400) or would you cumulatively increase the amount for each 10% drop (100+220+300+130+125=$875)?

  • Report this Comment On August 19, 2013, at 4:48 PM, sagitarius84 wrote:

    I also buy every single month. Add to 401K, IRA's, and taxable brokerage accounts.

    I cannot stomach simply waiting in cash for the drops to come. In reality, most investors put money every month or so. Few have a pile of cash to invest..

  • Report this Comment On August 19, 2013, at 4:51 PM, TMFHousel wrote:

    << In reality, most investors put money every month or so. Few have a pile of cash to invest..>>

    They don't have to be mutually exclusive!

    Thanks for great comments, all.

  • Report this Comment On August 19, 2013, at 5:00 PM, shooter9mm wrote:

    Look, I'm RETIRED, almost FULLY invested, with LITTLE additional cash to follow your advice, SOOO, give me a heads-up...........

  • Report this Comment On August 19, 2013, at 5:16 PM, daveandrae wrote:

    Two things-

    1. I've been investing in equities since June of 1998. Thus, I have already experienced two market "crashes."

    Here's the bad news...

    a. You can't time them

    b. They sure as hell don't start when the forward earnings yield on stocks like GE are at 7.5% compared to a 2.84% treasury bond.

    c. Crash from what? The s&p 500 is barely up 50% in market price over the last fifteen YEARS...which is abysmal given its historical context. Meanwhile, earnings have more than doubled over that same time period and are still climbing.

    Hell, given the disparity in yields and investor "sentiment", if anything's likely to crash, its the BOND market, not the equity market.

    Here's the good news-

    I've made my very BEST investments in 2002 and 2009. Thus, lifestyle changing fortunes are MADE in "bear markets" not bull markets.

    2. Cash, with the sole exception for emergencies, is an irrational holding in the portfolio of the long term equity investor.

    For not only does cash yield nothing in terms of its dividend payout, but once you factor in inflation and its evil twin, taxation, the return from cash is quite negative.

    The only sound reason why someone would hold a large percentage of cash is that they believe all other asset classes, be it real estate, gold, bonds, stocks, oil..etc..will be even MORE negative. Thus, cash is not an "asset class", cash a hedge against fear.

    History has clearly demonstrated that if you're going to be afraid of something, you should be very afraid of being out of the market during the next 150% uptick, which, once again, cannot be timed.

    Good day

  • Report this Comment On August 19, 2013, at 5:50 PM, 112340 wrote:

    I cannot see a market collapse. The theory of generational cycles is a simple explanation of human behavior. If an explanation is complicated, it is probably wrong. I learned many years ago that if you are not really well informed about a subject look a see if you can find the history. If so, it is probably correct. The long cycle indicates that we should be past the collapse. The last four major collapses were 1770's, 1860's, 1930's see a pattern. I am betting on it.

  • Report this Comment On August 19, 2013, at 8:39 PM, hbofbyu wrote:

    Daveandrae,

    You may need to go back further than 15 years to see the overall trends.

    A market can be overbought even if it is not technically overvalued.

    The ability to manage a company profitably in the midst of a low-growth/no-growth economy simply is not a compelling investment proposition. We are treading water.

    The Crestmont P/E ratio indicates overvalued.

    The CAPE or PE10 indicates overvalued.

    The Q ratio indicates overvalued.

    The regression to Trend on long term performance indicates over-valued.

    The only certainty in the stock market is that, over the long haul, over-performance turns into under-performance and vice versa. The trap lies in picking your time-window.

  • Report this Comment On August 19, 2013, at 8:50 PM, TMFHousel wrote:

    <<The CAPE or PE10 indicates overvalued.>>

    Siegel brought up an interesting point the FT this morning: "In fact, in all but nine months in the past 22 years the Cape ratio has been above its long-term average."

  • Report this Comment On August 19, 2013, at 11:08 PM, TMFDanielSparks wrote:

    Morgan,

    Great stuff here. I've never really thought about frequency versus magnitude in this regard. This read provided some seriously interesting food for thought.

  • Report this Comment On August 19, 2013, at 11:49 PM, daveandrae wrote:

    @hbofbyu-

    Those of us that have an ability to think for ourselves don't give a damn what the CAPE or PE10 says. Never have. Never will. At the end of the day, your portfolio is either a better investment than cash, or it is not.

    I've been buying and holding stocks for well over fifteen years, so I can tell you from experience that the next 20% move in the s&p 500 is both unknowable and meaningless. It's the next 100% move that matters. And we all know, or should know, which direction that's going to be.

    I own my own business.

    At this time last year, I had 230k in equity capital against 119k in long term debt.

    Twelve months ago, the dividend yield on my equity capital was roughly 3.46%. The interest rate on my debt was 5.27%.

    I restructured the debt side of my balance sheet between September and October of last year. By the time it was all said and done, my debt balance went up to 123k, but the aggregate interest rate fell down to 3.29%.

    Over the last twelve months I've grown the shareholder's capital side of my balance sheet by roughly 30%, which is more or less in line with the s&p 500. Meanwhile, the debt side of my balance sheet has fallen down by roughly 5%, or down to 114.4k.

    Thus, twelve months ago my debt to tangible equity ratio was roughly 52%

    119/230 = 0.517%

    Today, twelve months later, it's fallen down to 38%

    114.4/298 = 0.384%

    Does this look like a "bubble" to you?

    Keep in mind, I'm not running McDonald's, IBM, Apple, Starbucks or GE, I'm just running my little ole Mom and Pop shop. Now If I've done this with my little company's balance sheet over the last twelve months, can u imagine what THESE companies have been doing with there balance sheets given the historically low levels of interest rates?

    Food for thought-

    Good Day

  • Report this Comment On August 23, 2013, at 6:40 PM, JCoeur wrote:

    Interesting, but what is your reference level for a 'drop'? The market's historic high? The most recent 12 month high?

  • Report this Comment On August 23, 2013, at 6:54 PM, notgoing2argue wrote:

    I guess a better question is do you have an exit plan to avoid those 20, 30, 40 and 50% draw downs? Picking the top and bottom is impossible, but you can know which way the market is trending, which can help you avoid most of the big crash. Of course you will miss a little of the initial upswing once the crash is over, but I'd rather be a little late to the next bull party than hang around on the deck of the Titanic hoping we find the bottom of the ocean before I'm sunk.

  • Report this Comment On August 23, 2013, at 7:50 PM, bobbyk1 wrote:

    Not being a wise guy but Im not sticking around for no 30/50% drop.Im going to watch autos,housing and financials and get out when things get shaky.(thats the pla anyway)I was able to retire at 58 because I Jumped my 401k cotribution to 30% at the bottom.Good luck Fools.

  • Report this Comment On August 23, 2013, at 8:43 PM, StockGamingCom wrote:

    Back up the truck, the next time the market crashes.

  • Report this Comment On August 23, 2013, at 11:57 PM, enginear wrote:

    Cash management is a tricky problem... keeping it around because the market may drop is probably not a good idea, but we all have accumulation (of cash) periods, and periods that are fairly weak on cash.

    The analysis is good, but it requires the cash, and sometimes you have a lot, and sometimes you have only a little. If you reach 'critical mass' (Bob Brinker's term) perhaps keeping a set (fairly good sized) amount of cash is possible... for those of us in the under $250K club it grows and shrinks with events, and we just have to do the best we can

    Mr. Buffett has done very well deploying cash at the right time, but the dividend payout on one of his companies make my net worth look like lunch money.

    finally... this is really a plug for dollar cost averaging.

  • Report this Comment On August 24, 2013, at 10:38 AM, tprooney3 wrote:

    Nice article (as usual) Morgan, and lots of good comments and responses.

    Yes, we should all dollar-cost average. I allocate a fixed amount to my index fund and to my stock purchase fund each month. I also set aside and save $20 each month for deployment during the next market drop. It will not make me richer. In fact, it is purely an emotion-based strategy designed to meet two objectives:

    1. I hate watching the market drop, wishing I had more capital to deploy. Deploying extra investment capital during a downturn is emotionally-fulfilling.

    2. I have a decision rule that forces me to buy when others are fearful. Deploying extra investment capital during a downturn fosters discipline.

    In the final analysis, this strategy probably does not beat straight dollar-cost averaging. However, it does come with psychological benefits, at least for me.

  • Report this Comment On August 24, 2013, at 1:04 PM, DufferWD wrote:

    Morgan, isn't this market timing 'lite'?

    Perhaps a better use of downturns is a deeper evaluation of the businesses we're invested in. In other words (or Buffett's words) "Only when the tide goes out do you discover who's been swimming naked." Perhaps a re-allocation between our businesses we're Foolishly invested in is a better use of downturns. Holding cash on the side - even in a laddered way as suggested - seems to go against the Foolish way.

  • Report this Comment On August 24, 2013, at 7:39 PM, daveandrae wrote:

    two things

    1. The last time you could buy stocks like GE at 5 times their ten year average earnings was 2009 & 1979. Thus, if history is any guide, you're going to be waiting a loooooooong time before the market "crashes" again.

    2. A good friend of mine's Father got out of the market in 2007. He thought it was overvalued and due for a fall.

    Guess what?

    He was right!

    When the s&p 500 was at 700, more than 50% cheaper than it was when my friend's Father got out, I told my friend to tell his Father to get back in.

    He didn't

    At s&p 927, I said the same thing.

    He still didn't get back in

    Today the s&p 500 is trading above 1650. Well past it's 2007 high.

    Guess what?

    He NEVER got back in the stock market after selling out in 2007!

    Thus, you are deluding yourself if you believe you can "time" the stock market. I've been buying and holding equities for over fifteen years and even when the odds were overwhelmingly in their favor, I have never, ever, seen anyone time the market successfully.

    Good day.

  • Report this Comment On August 24, 2013, at 9:12 PM, lowmaple wrote:

    daveandrae: I sell some stocks if they increase enormously but often only a percentage. I then put in an order to repurchase them at several lower levels. That way you can still be in the market and hold important cash for great oppertunities. However some people are not able to stomach that approach. Also, don't get to greedy. Buffett wouldn't do that.

  • Report this Comment On August 25, 2013, at 12:39 AM, daveandrae wrote:

    lowmaple-

    I read your post three times and still doesn't make any financial sense.

    I will give you my reasons.

    1. With the sole exception of emergencies, cash is an irrational holding in the portfolio of the long term investor. For not only does cash yield next to nothing in terns of a dividend, but once you factor in inflation and its evil twin, taxation, the real rate of return from cash is quite negative. This is especially irrefutable at today's interest rates

    The only rational reason that I can think of why someone would hold a lot of cash is that they believe that the return from all of the other asset classes.....stocks, bonds, real estate, etc, will be even MORE negative.

    Thus, cash is nothing more than a hedge. I don't believe in hedging. Mostly because, as I have clearly shown, it doesn't work. I believe in buying and holding small pieces of great businesses.

    2, Selling incurs capital gains taxes, brokerages fees and sales commissions. Buying back incurs brokerage fees and sales commissions. Keep doing that over and over in a lifetime and the only person getting rich is your broker.

    Buffet wouldn't do "that" either.

  • Report this Comment On August 25, 2013, at 7:31 AM, TMFPennyWise wrote:

    Interesting subject, Morgan. A lot to think about.

    I found an excellent 5 part series of articles by TMF Alex Planes that may be of interest to readers here. It explains Secular and Cyclical Bull and Bear Markets and explores a lot of detail about market trends. The timelines and graphs illustrating the history of the market's volatility were especially helpful to me and his discussion of sociological factors that influence market trends was interesting.

    http://www.fool.com/investing/general/2013/02/25/the-complet...

  • Report this Comment On August 25, 2013, at 3:51 PM, Nolte808 wrote:

    Good article. A low frequency trading algorithm.

  • Report this Comment On August 26, 2013, at 7:45 PM, JadedFoolalex wrote:

    "The market always finds new ways to make fools out of us"

    - David Merkel,

    Aleph Blog.

    We don't know what the market is going to do, but, I've always thought that when the general press is reporting "irrational exuberance" in the markets, it's time to sell your calls!

  • Report this Comment On October 03, 2013, at 8:45 PM, comissar wrote:

    I'm a little late to this party, but wanted to add a different angle.

    The whole point of keeping some cash on hand for a market correction is to not miss the opportunity. But if you set aside some money for the once every 10, 20, or 50 year events, you miss the 7-10% per year average market returns. Keeping that theoretical $100 aside for an average of 50 years in order to take advantage of a one time 50% discount ignores the average 7-10% you could have made for those 50 years. This is a TERRIBLE return no matter how you slice it.

    The other problem is for that theoretical 10% correction, you can't time the bottom, so you would more likely only get 7-8 % out of it. When this is factored in, it's even worse. As DufferWD and others mentioned, this is sort of like "market timing lite".

    The only period for which this makes any sense is the one year, 10% correction case, and at that point it's really generic opportunity money - whether it be a market correction or a great company that you've just discovered.

    What I do is a variation on what a lot of others have mentioned. Keep adding cash on a regular contribution cycle. Add in any dividends. Add cash from liquidating a position that you've decided is past it's prime. Keep piling the cash up, and that is your opportunity reserve. When it gets to be too much (in my case, about 3-5% of my portfolio, but also determined by how small an amount you can economically invest at a time), you take whatever is available and hit the best opportunity(s) you can find at the moment - a new position or add to an existing one. I don't like to let more than that sit in cash for more than a month or so.

    In my opinion, presuming you have a separate cash reserve to live on in an emergency and aren't nearing retirement, being nearly fully invested is the ONLY way to go.

    Stan

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