Investors saw a little bit of everything in 2020. The stock market started the year by rising to new highs, only to suffer a lightning-fast bear market plunge that lopped 30% off major market benchmarks in a matter of weeks. Yet the stock market then bounced off its lows during the worst pandemic in a century, returning to record levels and beyond. There's never been a better testament to the value of having a long-term investing mindset.
However, your experience of 2020 might have changed your views on how you want to manage your portfolio. For many, 2020 was the first bear market they'd ever gone through, and even though things turned out for the best, it was still painful to endure. Moreover, there's no guarantee that the next bear market will be just as short.
Preparing for a market crash in 2021 is a smart move, especially right now in the middle of an impressive bull market run for stocks. But if you think I'm telling you to sell off all your stock positions and hide until the market tanks again, think again. Fortunately, there's a better way that doesn't require a crystal ball or perfect timing to offer the protection you need with your long-term investing strategy.
Why so many investors fail to protect themselves
The key to getting through a stock market crash doesn't have much to do with what investments you own. What matters much more is your perception of the investments in your portfolio -- and whether you're being realistic about what your reaction will be when the market crash actually happens.
Historically, most investors have thought about portfolio risk in terms of basic asset allocation . If you're nervous about your portfolio, cutting stocks in favor of bonds and cash was the recommended move. If you're comfortable with risk and want to get more aggressive, move more heavily toward stocks.
To figure out the right asset allocation, many people rely on risk tolerance questionnaires. These one-page documents typically ask overly simplistic and theoretical questions about what you would do in a market plunge -- questions that are almost impossible for anyone to answer realistically, particularly if they've never seen a market crash before.
The questionnaire is meant to give you a sense of what your overall allocations to stocks, bonds, and cash should be. But that still leaves unanswered questions about granular details, such as which stocks to buy or sell and how to handle big concentrations in certain individual stocks.
Finding the right balance
If you invest primarily in index mutual funds and ETFs, then the traditional rebalancing approach works quite well. If your stocks have done better than the rest of your portfolio -- which is fairly likely, given relative returns this year -- then you'll sell off a small portion of your stock holdings and add it to bonds, cash, or other asset classes in your investment strategy. As long as that mix accurately reflects what you're comfortable with happening in a crash, you should be all set.
For investors in individual stocks, it's more complicated. You'll need to consider issues like these:
- Are you heavily invested in high-growth stocks that could see big pullbacks in a crash? Consider lightening up your concentrations in that area in favor of promising stocks with different investment characteristics.
- Do you hold value stocks that have already lost ground in 2020? If you think they'll do well in the next market crash, you might find that you don't have as much of your total stock exposure to those particular value stocks as you thought. Shift money toward value to remedy that.
- Have a few winning stocks become massive positions? Selling winners too early is often a big mistake, but if a single stock represents more than 50% of your total holdings, a slight trim to provide cash to buy shares of other high-potential companies could make you feel more comfortable in a market downturn.
Be ready for anything
Of course, you simultaneously need to prepare for the possibility that there's no stock market crash in 2021. Making modest changes is generally smart because you don't want to miss out if the market happens to go up again in 2021. Given the market's history of having more up years than down, aggressive changes are likely to cost you.
If 2020 taught us anything, it's that anything can happen with your investments. Preparing for a crash now will enable you to act when the time comes without falling prey to costly emotional decisions.