If all you had to judge the state of the economy was the stock market, it would seem like everything is fine. After falling 34% in barely over a month in February and March, the SPDR S&P 500 ETF Trust (NYSEMKT:SPY) has surged 37%, and is down only about 5% since the beginning of the year.
This alone -- such a disconnect between stocks and what is happening in the real world -- has many investors convinced another market crash is inevitable. But is it? Absolutely. There's no doubt we will see another stock market crash again. Let's talk about how you can prepare.
The most important thing to know
We don't know when the next market crash will happen. As much as it may feel like it's inevitable, we simply don't know. The past 10 weeks is an excellent example of how making a prediction on market crashes is nearly impossible.
Think about it this way: On March 23, 3.3 million people had newly filed for unemployment under lockdown efforts. At the time, 31,000 Americans had been diagnosed with COVID-19, and about 400 had died. On that date, the S&P 500 hit bottom, down about 34% from the high on Feb. 20.
Fast-forward to today, and there are almost 1.8 million confirmed COVID-19 cases, more than 104,000 Americans have died, and millions more people are out of jobs as unemployment has skyrocketed to almost 15%. Yet the market is 37% higher than it was 10 weeks ago.
It's a reminder that in the short term, calling the top -- or bottom -- with stocks is pure luck.
The biggest mistake to avoid
Which brings us to the mistake to avoid: selling stocks to try and time your way around the next market crash. There are millions of people on the sidelines today who sold sometime in late March or early April, convinced things would get worse before they got better. Instead, they've missed out on the massive -- inexplicable -- stock market rally since the late-March bottom.
The trick with stocks is to remember there are no tricks. Stocks are ownership in businesses. Many are being hammered by the impact of COVID-19; some won't survive. But the best businesses will come through this and return to growth as the world moves past this crisis. The hard part is riding out the downturns so you can profit from the return to normal.
Stocks are incredible long-term sources of wealth creation. This is true even if you buy at what seems like the worst possible time. For example, if you invested in an S&P 500 index fund like the SPDR S&P 500 ETF Trust in early October 2007, the next couple of years would have felt awful.
But even for people who bought at the peak of the prior crash, stocks have delivered wonderful gains. Even from the pre-Great Recession peak to the bottom of the coronavirus crash this year, stocks outperformed bonds, as represented by the Vanguard Total Bond Market ETF (NASDAQ:BND):
Stocks have a long history of outperforming the "safety" of bonds over long periods of time, even from the "worst" time to buy before the prior crash, to the "worst" time to sell at the most-recent market bottom.
The first action to take with your long-term investments is no action. The odds are much greater that you'll profit if you leave your stocks alone and let the power of owning great companies for many years pay off.
Selling on the idea that you're "getting out" before the next crash has sure proved a mistake for a lot of investors this year. History makes it clear: Time in the market works; timing the market doesn't.
Actions you can take to be ready for the next crash
So what can you do to be ready for the next crash? Make sure you have cash ready for three important -- but separate -- things:
- Unexpected expenses
- Expected expenses
- Investing to profit from the next crash
Create an emergency fund
Recessions, job losses, illnesses, natural disasters, and a litany of other things can happen unexpectedly. In addition to having appropriate kinds of and amounts of insurance, you should aim to have cash savings that can cover six or more months of basic living expenses.
Your need for this money may occur with or without a market crash; having an emergency fund means you won't be forced to sell stocks to cover unexpected expenses at exactly the time you should be buying.
Protect the assets you'll need soon
While your emergency savings is preparing for unexpected near-term needs, you should also prepare your portfolio for those expected needs coming up soon.
For this reason, it's a smart idea to start shifting a portion of your investments away from stocks and into high-quality bonds and cash several years before retirement, sending a kid off to college, or whatever you've been investing for. The goal is having a few years' expenses in these low-volatility assets before you need them.
Sure, bonds and cash don't yield anything close to what you can get from dividend stocks, and you'll miss out on the upside prospects of stocks. But at this point in your financial journey, your goal should be to limit the downside of unexpected losses for money you'll be counting on in the next several years.
Setting aside cash to invest in the next crash
We've already addressed the risk of moving too much of your portfolio to cash. Can you imagine having moved heavily into cash in late March (maybe you can) only to watch stocks come roaring back? If that's you, it is probably going to be really hard to go back into stocks at this point. But history makes it clear that it's a big mistake to play the short-term guessing game only to miss out on the long-term winning strategy of buying and holding.
So with that said, one useful strategy is to keep a small portion of your portfolio -- say, about 5% -- that would normally be invested in stocks, and hold it in cash to invest when the market does drop quickly.
Here's the plan I use with the cash in my portfolio:
- When stocks fall 10% from a recent high, I invest half the cash in my portfolio.
- When stocks fall 20% from a recent high, I invest half the remaining cash.
- When stocks fall 30%, I invest the remaining cash.
Why those levels? In short, because we see 10% declines about once every year or two and 20% declines about once every five to seven years; a 30% decline has happened only six times in the past 70 years. Holding cash for bigger drops is a losing move since the market has always recovered far more than it lost before falling 30% or more again. Sure, it's possible we could see another 30% drop in the next year or less; it's that history says it's not a probability worth betting the farm on.
A winning strategy for today and tomorrow
The plan above can help you avoid the following wealth-destroying actions:
- Committing the unforced error of selling stocks just because the market is crashing, only to miss out on the recovery by sitting in cash.
- Committing the forced error of having to sell in a crash because you need money now.
- Keeping too much cash on the sidelines for the next crash and hurting your long-term returns.
If you're sitting on a ton of cash, counting on another big crash happening soon, look to history as a guide. Stocks could fall again soon, or it could be years -- and a lot of gains -- before the next big drop. On the other side of the coin, if you're too exposed to stocks with assets you'll need to cash out in the next few years to pay for some financial need, it may be time to sell some of your holdings and get your asset allocation in order.
Either way, if you don't have a firm plan in place that covers your short-term and long-term goals and needs, it's time to put one in place and start acting on it. You'll be in much better shape when the next market crash does happen, whether it's this year or many years from now.