Reacting to a market crash is easier said than done. That's why it's better to have your portfolio prepared to withstand such a tumultuous situation prior to it actually happening.
The last decade has seen a very low-interest-rate environment. That has dampened the returns investors can get from things like bonds and other fixed income. To retain those returns, equities have been the only game in town. This has fueled a market run where the stocks have achieved very high premiums compared to actual earnings, and in comparison to total equity.
It's foolish to attempt to say exactly when another market crash could occur. These are three steps everyone can take to be ready for when that day comes.
1. Retain dry powder
The best way to handle a market crash is to find a way to benefit from it. Having cash on hand to buy opportunities that present themselves is the way to do just that.
Learn from Warren Buffett. Buffett makes some of his biggest plays during volatility. He can do so because he keeps ample cash on ready to use. He speaks often about how inflation eats at the value of cash, but Berkshire Hathaway (BRK.A -1.30%) (BRK.B -1.31%) tends to keep billions in cash on hand for when opportunities arise.
Trimming off of some investments that have made big gains is a way to lock in profits, while also putting some cash in hand to be able to take advantage of a market crash. Conversely, it might be more tax efficient to trim off of positions that have done poorly. Cutting one's losses isn't always a bad thing.
2. Manage risk
Preparing for a market correction is a lot about the quality of your portfolio. You can't necessarily just completely set everything on the sidelines waiting for a downturn; especially if you're invested for retirement. What you can do is make sure you're invested in quality entities. A lot of the best performing names this year have been tech-related growth stocks. The market as a whole has been imbalanced in its rush to all-time highs. Overexposure to stocks based on growth momentum, or the balance sheet's total equity, could be setting your portfolio up for pain.
Seek out the weak links in your portfolio, and remove them from the equation. Focus on safer stocks that can carry you through.
3. Keep focused on the long term
Panic is the enemy of all. Just because your investments went down does not mean they will stay down. If you've bought sound companies that are primed for business success over the long run, don't worry about short-term turbulence. Those investors who sold too much in the spring of 2020 likely live with some regrets.
If you see some things that are directly correlated with the crash, or a company that might face bankruptcy or irreversible damage, those investments might need to be dumped. Similarly, altering performance between equities, fixed income, commodities, etc. will require corresponding adjustments. Those moves will be much easier if your portfolio has already been reviewed and your risk reduced. Overall, it's important to keep your cool and look at the long term.
Having some free cash prepared and ensuring your portfolio isn't overly risky are important things to keep in mind when the market is this high. At the same time, it's important to keep perspective. Long-term investors tend to do better when they don't over-adjust to a short-term market swing. Over time, the market has only gone in one direction. Sudden shocks in volatility can cause investors to forget that.