In spite of seemingly insurmountable odds back in March, it's likely the U.S. stock market will close out 2020 in positive territory. With just a few weeks left to go, the S&P 500 is up 14% on the year.
As difficult as it may be to grasp, a massive rally following a precipitous drop is the norm for stocks, even if the economy overall remains in recession. But the market doesn't rally higher in a straight line. There are bound to be bumps in the road, mini crashes, and other setbacks. Here are three ways to get ready for the next one.
1. Be mentally prepared for turbulence
Remember when we used to fly on planes? Occasionally, the captain would get on the intercom to let you know some turbulence was ahead, giving passengers some time to mentally prepare beforehand. Here's a similar advance notice headed into 2021: First-quarter turbulence isn't uncommon. Remember last March during the lockdown-induced panic?
I expect some headwinds in the first quarter of 2021 as well. It's wintertime in the northern hemisphere where the majority of the world's population lives, and a post-holiday season slowdown leads to lower economic activity. This year, there's also political intrigue, and a second smaller round of stimulus (or no stimulus) could be a letdown. Not to mention there's a deadly virus still going around. Vaccinations against COVID-19 may not go smoothly. There are logistics with the delivery of the vaccine that could go wrong, and there's no telling how many people will opt into getting immunized.
Put simply, there are all sorts of reasons the stock market could decide to go haywire and give back 10% or more of its value (the definition of a "pullback," or "crash" in layman's terms). Being prepared for the inevitable downturns -- before they happen -- is always wise. Mental preparedness lessens the likelihood we make a rash decision we later regret. Know the pullback is coming, but be resolved to stay focused on the long-term rather than get hung up in the moment.
2. Raise some cash in your account
I like to always have some cash on hand (or cash equivalent, like a money market account or short-term bond fund). It's a nice cushion against volatility since it doesn't decline in value. But how do you raise cash, besides making cash deposits into an investment account?
I'm a fan of doing some tax-loss harvesting -- slimming down on or selling out of losing positions before the end of the year -- to raise cash. If done in a taxable investment account, selling losing stock positions can offset any realized gains and reduce tax liability. If realizing losses on an investment exceeds realized gains, most investors can write off up to $3,000 (or $1,500 if married filing separately) to reduce taxable income and carry over any excess above that to future years.
Besides a tax break, selling long-term losing stocks increases cash and puts an investor in a position to make a portfolio upgrade by purchasing a new (or more of an existing) long-term winning investment. Thus, even in a retirement account, getting rid of losing investment positions bogging down long-term performance is often a sound strategy toward maximizing returns.
3. Get a shopping list ready now
Speaking of making a portfolio upgrade, the other half of selling losing investments is getting ready to put the money back to work somewhere else. Part of advanced mental preparedness is knowing what you'll buy. Time to start putting a purchase list together now so a market crash has less chance of convincing you otherwise.
And as the saying goes, oftentimes the best buy is already in your portfolio. Long-term winners tend to keep winning and compounding your investment returns over time. And technology -- along with the businesses putting it to good use -- looks especially well-positioned to do well in the new digital era COVID-19 has helped create.
Some of my personal favorite long-term winners have already pulled back recently, like salesforce.com (CRM 3.22%) after its announced acquisition of Slack. Digital payment stocks like Visa (V -0.09%) -- another one of my long-term winners -- are still clawing their way back to growth mode and should continue to benefit from secular growth trends over time. PayPal (PYPL 3.54%) is another one that has continued to grow even during the pandemic because of its outsized reliance on e-commerce. And speaking of e-commerce, top performers from the last year like Etsy (ETSY 8.22%) and Pinterest (PINS 2.11%) would be near the top of my list to purchase more of whenever the market decides to head south again.
The point is, be ready with a plan of action before negative emotions that come with a market "crash" are running high. Know the turbulence is coming, have some cash handy, and have a plan of attack once the sell-off happens.