Someday -- and I don't know when -- the stock market will crash. When it happens, it will feel like someone has robbed you, siphoning hundreds or thousands of dollars (or more) from your retirement account. You'll get angry. You might even wish you'd never put your money in the market in the first place. But here's a simple lesson I've learned from decades of investing. You can't avoid the crash-fueled rage, but you can lighten its intensity by having a plan.
Having a plan keeps you grounded in the face of bear markets and stock market freefalls. When rage, frustration, or disappointment beg you to sell out and cut your losses, your plan is the gentle voice of reason. It stifles that self-defeating conclusion that you don't know what to do next or how you'll ever recover. You know exactly what to do, because you thought through the crash scenario before your head was filled with all those crazy emotions.
As 2020 comes to end, it's a great time to develop your crash plan for 2021. I like to combine this effort with an annual review of my holdings, allocation, and retirement timeline. That way, my crash plan is informed by how much risk I have in my portfolio now and how much more I'm willing to accept. Here is my four-step process.
1. Review the portfolio
Investors will often move out of their riskier positions when the market starts to show signs of volatility. It's known as the "flight to quality." Personally, I don't follow that practice. I prefer to fly in the quality zone at all times. If a position is something I'd plan on dumping when the market gets dicey, I'm not likely to buy it. Call it laziness or ultra-conservatism or something else, but I don't want the job of deciding when volatility should prompt trading decisions. I'm certain I would get that wrong at some point.
Since I'm not waiting for the market to prompt a quality upgrade in my portfolio, I do this proactively during an annual portfolio review. That way, whether a crash happens suddenly or slowly, I'm prepared.
2. Rethink the retirement timeline
Admittedly, I'm not crystal clear on my retirement timeline. My guess is that most people aren't, until a job loss or health problem kicks you out of the workforce unexpectedly. I deal with the uncertainty by planning to work late into my 60s but also saving excessively in case that turns out to be impossible.
From an investment standpoint, my willingness to work indefinitely does lead to a riskier asset allocation than many advisors would recommend. According to the Rule of 110, I should have roughly a 60/40 split between equities and fixed income given my age. But I'm actually sitting on an 80/20 split. The higher percentage of equities gives me more opportunity for growth but also adds volatility. If the market does crash in 2021, I will feel it. But it's a risk I can accept -- for now, anyway -- given that I plan on working for another 20 years. I like the quality of my portfolio, and I'm disciplined about saving.
3. Check the emergency fund
The emergency fund is a critical component of your crash plan. Presumably, you don't plan on selling off your positions at the bottom of the market. But you may not have a choice if you don't have extra cash on hand. After all, if a pipe is going to burst underneath your finished basement, of course it will happen just after the market takes a dive. In that scenario, you want to pull the money from your cash stores and not your investment account.
I add to my emergency fund monthly with an automatic transfer from my checking account. In this year-end review, I'll look over how the balance has changed throughout the year and adjust my monthly contribution accordingly.
4. Set the rules
After reviewing my holdings, retirement timeline, and emergency fund balance, defining the details of a crash plan is fairly straightforward. Personally, I only allow for two options: Do nothing or buy. In 2021, my plan is to buy more of what I own currently, as long as my emergency fund balance is over a certain threshold. Otherwise, I'll do nothing and wait for a recovery.
When defining your plan, think about your debt levels and financial goals for the next few years, as well as your emergency fund balance. For example, if you want to pay down debt or buy a car, it probably doesn't make sense to invest after a crash.
Generally, if you're young, employed, and financially stable, a market downturn presents a nice buying opportunity -- it's like a warehouse sale for investors who can afford to wait for a recovery. But if you're older, living paycheck to paycheck, sitting on a lot of debt, or uncertain about your job, you're wise to sit tight and do nothing after a crash. In that case, cash on hand serves you better than stocks, which may take their sweet time turning a profit for you.
Write it down
Remember to write down your crash plan, along with the thought process behind it. Once your portfolio is in order and your plan is documented, you can head into 2021 knowing you're ready for whatever craziness the market might send your way.