Prepare for the Crash

The stock market crash after the Internet bubble destroyed portfolios -- and dreams. The Nasdaq fell from 5,000 to less than 1,200 -- nearly an 80% decline. And that's only an average. Many stocks became essentially worthless. The tragedy wasn't in the numbers, though. It was in the effect those losses had on people. Many investors were completely wiped out, losing money they'd been saving for years.

This really isn't the sort of pain you want to experience firsthand. That's why it makes sense for all investors to have a portfolio that's prepared for lean times. If a terrible day ever comes, you'll want to make sure you suffer only a flesh wound, not decapitation.

At Motley Fool Inside Value, we specialize in identifying stocks that not only outperform on the upside, but can also survive a crash relatively unscathed.

Diversify now
Investors with technology-focused portfolios suffered the most a few years ago. There was almost nowhere in the sector to hide, with even the strongest companies suffering huge declines. Qualcomm (Nasdaq: QCOM  ) fell 88%, Tellabs dropped 94%, and LM Ericsson (Nasdaq: ERIC  ) plummeted 98%. Even now, these companies aren't close to their pre-bubble highs. And again, these are some of the strongest companies in the sector.

The moral of the story isn't that technology companies are risky, but rather that diversification is a key component of a crash-resistant portfolio. While tech has been dreadful, the Vanguard REIT Index would have doubled your money since 2000, and energy stocks have had outstanding returns as well. A diversified portfolio that included technology, real estate investment trusts, and oil would have prospered. Diversification also ensures that you get the full benefit of your stock-selection skills. The crash demonstrated that it's no condolence to identify the best-performing stocks in the worst-performing sector. Being the best of the losers doesn't make you a winner. But if you pick the best of each sector, you'll do quite well.

Buy cash
The problem with the companies that fell the most when the bubble burst was that they had neat ideas but didn't actually make any money. Even some of the most popular companies had this problem, such as Sonus Networks (Nasdaq: SONS  ) , one of the hottest IPOs of 2000. Before the crash, Sonus was drowning in red ink, having never had a profitable year. But investors assumed that it would be a great investment because it was in the hot networking space and was showing strong revenue growth. Investors were willing to pay huge prices for a relatively untested company. That was a costly mistake.

Unprofitable companies have little flexibility in bad business climates, and they tend to do poorly in bear markets. In a panic, investors aren't buying dreams. They're sticking with consistent cash machines, steady blue-chip companies such as Ecolab (NYSE: ECL  ) and ExxonMobil (NYSE: XOM  ) . It's no coincidence that these two companies show spectacular long-term returns, unfazed by the last bear market. Businesses that earn gobs of cash don't have to raise money to survive. They can even take advantage of poor conditions to gain market share from weaker competitors. Such businesses tend to be crash-resistant.

Be skeptical
One of the best ways to guard your portfolio against a market crash is by maintaining a healthy level of skepticism. Wall Street isn't a charity; it's a bunch of businesses focused on making money for themselves. Helping small investors make a profit is item No. 382 on the list of Wall Street priorities, immediately below ensuring that the new assistant knows exactly the right amount of milk and sugar to put in everyone's morning coffee.

Be skeptical of analyst forecasts, whether they're predicting that oil will hit $110 a barrel or that ADC Telecommunications will break $175 a share. While ADC's price targets were trumpeted on TV before the crash, I haven't seen many apologies for the stock's subsequent performance. It's now trading at around 10% of the price target set back then.

Rather than blindly trusting the analysts, make sure you understand the companies you're buying. Understand what risks each business faces, and what competitive advantages will help the company overcome hurdles. Be particularly wary of high growth estimates, because analysts tend to be optimistic, and high growth is difficult to sustain. If the company fails to achieve overly ambitious growth estimates, the stock will get hammered. Finally, buy a stock only if conservative analysis shows that the company is trading at a bargain price. Since stocks tend to return to their intrinsic values, buying below that value provides significant protection in a crash.

Foolish final word
While a crash will hurt any portfolio, a few carefully chosen strategies can help you avoid the worst and give you the opportunity for big gains along the way. If you're interested in reading our recommendations, we offer a free, no-risk 30-day trial, which gives you access to all issues, a discounted cash flow calculator, and dedicated discussion boards.

Whatever you do, start planning your blueprint for a bear-resistant portfolio.

This article was originally published Sept. 28, 2005. It has been updated.

Fool contributor Richard Gibbons is scared of stock market crashes, large flying objects, and eerie music. He does not own shares of any of the companies mentioned in this article. The Motley Fool has a disclosure policy.


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