Investors have been on a roller-coaster ride in 2020. So far this year, investors have experienced one of the sharpest, quickest market crashes in history in March. But despite the fact that the U.S. economy remains in the midst of one of the worst recessions ever, the SPDR S&P 500 ETF Trust (SPY -0.05%) is back to about breakeven for the year.
Meanwhile, the numbers of daily new COVID-19 diagnoses in the country have been rising sharply over recent weeks, and the daily death tolls, after moving lower as early hot spots got their outbreaks in check, are ramping higher again. This has many investors looking at the stock market's prospects and coming to the conclusion that this incredible rebound will come to an end sooner rather than later.
Don't ignore the hidden risk of cash. Image source: Getty Images.
Are you prepared? What steps should you take to be ready? Let's take a closer look at what you can do to make sure you have enough cash for the next market crash, and most importantly, that your portfolio is built to help you maximize your chances of reaching your personal financial goals.
Use this approach to build your cash investing strategy
Another stock market crash is certainly going to happen. The problem: Nobody knows when it's going to happen.
One only has to look at the first half of 2020 for proof of the difficulties of accurate short-term market prediction. In recent years, various prognosticators have warned that growing debt, the federal deficit, inflation, and a litany of other things would be the catalysts for the next market plunge.
Guess what none of those investing experts was predicting? A global pandemic.
The S&P 500 reached an all-time high on Feb. 20. By March 23, it had fallen 34% in 33 days, its fastest 30%-plus drop in history. Then something just as unexpected happened: An unprecedented amount of federal government stimulus and financial support helped prop up the economy. Even in the midst of the worst employment crisis since the Great Depression, the stock market came roaring back.
Few were expecting that unusually fast recovery either.
But instead of viewing this short-term uncertainty as a risk, investors have to accept it -- even embrace it -- as part of what makes stocks superior long-term investments.
Two legends can help change your thinking
Charlie Munger, vice-chairman of Berkshire Hathaway (BRK.B -0.68%), doesn't get enough credit for influencing Warren Buffett's evolution as an investor. He's well-known for having said, "Invert, always invert." This phrase is deceptively simple, but it's powerful in helping people reframe how they think about investing.
Let's invert the way we think about cash. Instead of focusing on the unknowable question "When will stocks crash," let's think about what we do know: At some moment you can't predict, you will be hit with a major unexpected expense, and you should have emergency savings set aside to help you cover it. By contrast, you can know (roughly) when you'll retire or when a child will start college, plan for the timing of those costs.
By inverting the question to "What do I know about the financial future?", you can allocate cash appropriately based on your short-term and long-term goals. For instance, if you're still 20 years from retirement, it makes far more sense to plan on riding out market crashes to take full advantage of stock returns over the long term. (But don't just plan: Do it. Do not panic and sell when the next crash hits.)
Our second investing legend, Peter Lynch, said it best (boldface mine for emphasis):
Long term, the stock market's a very good place to be. But I could toss a coin now. Is it going to be lower 2 years from now? Higher? I don't know. But more people have lost money waiting for corrections and anticipating corrections than in the actual corrections. I mean, trying to predict market highs and lows is not productive.
Lynch is one of the most successful investors of the past century. If he couldn't find a productive way to predict the market's short-term ups and downs, you probably shouldn't try to either.
Set aside cash for these things
When you're trying to determine what sort of resource allocation makes sense for you, there are a few key points to consider. First, you need to think about divvying up your excess cash appropriately to handle these three purposes:
- Unplanned expenses (emergency savings)
- Loss of employment
- Repairs (home, car, etc)
- Medical expenses
- Planned expenses
- Child's upcoming education expenses
- Upcoming retirement expenses
- Large purchase (home, boat, etc.)
- Investing
- Regularly planned investing
- Market crash investing (dry powder)
The mental shift that will make you wealthier
Once you stop trying to plan based on what stocks might do in the near term and concentrate on optimizing your portfolio -- and your actions -- to reach your financial goals, you'll find it much easier to focus on the bigger picture. The next market crash will no longer be a risk to avoid, but partly an opportunity to take advantage of and, otherwise, just a rough patch to ride out.
I'll use my situation as an example: At 43, the main financial goals I'm investing for are many years in the future, so the vast majority of my portfolio is in stocks. However, I've still built up some cash reserves over time, to a maximum value of about 5% of my portfolio (not including emergency savings).
This cash serves two purposes: First, it gives me capital to deploy for bargain hunting when the market crashes and great stocks fall, often for no reason. Second -- and more importantly -- it helps me avoid the mistake of selling perfectly good stocks just because the market is dropping. Call it an emotional hedge.
Cash is a powerful tool, but it's also value-destroying if you hold too much of it waiting for a market crash that could take years to arrive. Money sitting idle in the bank loses value over time, and there's a major opportunity cost to eschewing stocks to hold cash. A better approach is to build your portfolio around what you know and can control, and invest in the right assets to help you reach your long-term and short-term goals. This strategy has paid off enormously in my efforts to build my personal wealth, and I expect it can pay off for you, too.
