One morning in late August, the Dow Jones Industrial Average plunged by about 1,000 points, horrifying many investors. Many panicked and gnashed their teeth and sold out of various companies. Others, though, smiled -- because a stock market crash can be a wonderful thing.
What's so good about the stock market plunging? Well, it present big bargains, offering lots of high-quality stocks (or broad-market index funds) at suddenly lower prices. It's a relatively common occurrence, too, so be prepared for many downturns during your investing life. As my colleague Morgan Housel has advised, "Markets crash all the time. You should, at minimum, expect stocks to fall at least 10% once a year, 20% once every few years, 30% or more once or twice a decade, and 50% or more once or twice during your lifetime."
Beware of emotions
Unfortunately, many times our emotions get in the way when we're faced with financial decisions to make. When the stock market tanks, for example, lots of people succumb to fear and sell – which is precisely the wrong thing to do. (It's fine to sell for good reasons, of course, such as if you have lost faith in a company's future potential or you have found a significantly more promising investment.) Even if we don't make the mistake of selling in a market downturn, many of us do still let fear overcome us, keeping us from buying. It can be hard to place an order to buy a stock when its price has fallen because so many people have sold it.
The proper perspective
Superinvestor Warren Buffett offers a handy perspective with an edible analogy in his 1997 letter to shareholders:
If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves. But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
Your time frame matters a lot here, as Buffett noted. If you're still in your adding-money-to-your-investments phase of your life, as most of us are for decades, then lower prices are a good thing.
A market crash is bad news for some people, such as retirees who are living off of their investments -- but only if the money they will need within the next five (or, to be more conservative, 10) years is in the stock market. We're all advised to move such shorter-term money into more stable investments, such as CDs and money market accounts. Do so, and a market crash shouldn't derail your retirement. You'll have time to wait for a recovery.
The downturn can be short
When the market crashes, or less extreme, undergoes a correction, it's best to act fast, because a recovery can sometimes happen quickly. The late-August crash had the Dow down more than 6% in the morning, but ending the day down only 3.6%. A few days later, the Dow surged more than 600 points -- its third-largest gain ever, in terms of points.
My colleague Sean Williams has noted: "Not counting our most-recent dip in the Dow, corrections in this century have averaged 87.8 trading days, or about 17 calendar weeks. In other words, stock market corrections often tend to be on the order of a few weeks to two quarters in length."
In order to best position yourself to take advantage of a market drop, it's smart to not only keep some of your portfolio in cash, ready for compelling opportunities that arise, but also to maintain a watch list of stocks that interest you. Your list can be a simple list, kept on a page of a notebook, or it can be even more useful than that. For example, maintain it as an online portfolio, so that you can see the price movements of the stocks over time. You might pretend that you bought a share of each on the day that you added it to the list. Do so, and after that, you can see at a glance how much it has risen or fallen since it joined the list. When the market plunges, you'll be able to easily see which stocks have fallen the most.
For an even more meaningful watch list, you can enter each holding at what you estimate its intrinsic value to be. So if you think Scruffy's Chicken Shack (ticker: BUKBUK) is worth $45 per share and it's currently at $48, you can add it to your online portfolio as if you bought a share at $45. Then, every time you check the portfolio after that, you can immediately see how much above or below its intrinsic value the stock is trading for, helping you zero in on the most attractive opportunities. Note that with this more labor-intensive approach, though, you'll have to keep up with the holdings and update your estimated values over time.
The downturn can be long
A market correction isn't always short, though. Think back to the decade from the end of 1999 to the end of 2009, often referred to as "the lost decade." The period featured two bear markets, with New York Stock Exchange-traded stocks averaging an annual loss of 0.5% during it. That might have you thinking that some market downturns are to be greatly feared. Again, this lull was painful for those who weren't net savers, but here's an interesting and often overlooked fact: Those who kept socking money away into the market during the lull eventually came out ahead.
Fidelity Investments, which manages the 401(k) accounts of millions of Americans, reported: "Even during a decade that included unprecedented volatility coupled with two of the worst market downturns in history, analysis of employed participants with a Fidelity 401(k) plan for the past 10 years (1999 to 2009) showed their account balance increased nearly 150% to $163,900 at the end of 2009 from $65,800 at the end of 1999. The increase in balance was due to continued participant and employer contributions, dollar-cost averaging, and market returns."
It's hard to go wrong if you keep adding to your long-term investments in the stock market -- especially during downturns.