Market crashes are painful, but they can also bring huge opportunities. Moves made in a bear market will often have an outsize impact on your overall returns, and many of history's most successful investors built their fortunes and cemented lasting legacies by capitalizing on volatility and uncertainty.
With that in mind, we put together a panel of Motley Fool contributors and asked each member to share some investing wisdom that will help you thrive amid challenging market conditions. Read on for three tips on how to build wealth while others might be losing their heads and their shirts.
1. Leave the panicking to others
Keith Noonan: Portfolio-shaking market crashes are a fact of life for investors. Their arrival is both inevitable and difficult to predict with any meaningful consistency, and that dynamic deters many people from ever purchasing a single a stock. Acknowledging market volatility as a given and focusing on how you can withstand and use it to your benefit will make a huge difference in your returns over time.
It's also worth mentioning that flash crashes and other signs pointing toward doom-and-gloom scenarios are much more common than actual market crashes. We don't have to travel far back in time for an example.
The Nasdaq Composite index got rocked by steep sell-offs on Feb. 23, and technology investors who checked their portfolios early in the day's trading probably saw some gut-wrenching losses. At the worst of the rout, my tech-heavy non-retirement portfolio was down roughly 10% on the day -- certainly cause for concern. However, the market recovered substantially within the day's trading. By the closing bell, my growth portfolio was down only 1.5% -- basically a blip on the radar in the scheme of things.
The broader market, and the Nasdaq in particular, has continued to see volatile swings in subsequent trading, but my portfolio value hasn't come close to touching the recent low hit during the worst of the Nasdaq's recent flash crash. It's certainly possible that tech stocks are due for a bigger near-term pullback that also drags the overall market lower, but that kind of volatility is a risk investors always have to consider, and maintaining a steady approach to building high-quality investment positions will generally serve you well over time.
Sometimes what looks like the start of a sustained crash winds up being a relatively short-lived bit of fluctuation. Sometimes an actual market crash will hit, and you'll have a chance to buy up stocks at a life-changing discount if you persist through the fear and prioritize backing great companies. Missing out on the market's best days will seriously hurt your overall returns, and missed profit opportunities can compound if you wait to buy back in with expectations of eventually getting a cheaper price. Don't let fear of a short-term crash overshadow the potential for long-term prosperity.
2. For a small number of investors, this option trade is a good defense
James Brumley: I'll preface my suggestion by saying it's probably not the right defensive strategy for most people. But, for the handful of investors with the knowledge and approval to trade them, put options are a great way to make some short-term money when a market-wide sell-off is dragging your long-term stock holdings lower.
If you're not familiar, an option is essentially the right to buy or sell a particular stock -- or an ETF like the SPDR S&P 500 ETF Trust, or even an index -- at a predetermined price by a specific point in time. You buy call options if you think the underlying instrument is primed to move higher, but a put option actually gains in value as a stock, index, or fund loses value. See, a put option gives its owner the right to sell at a certain price. If that underlying index or stock falls, the right to sell it at a higher-than-market price increases in value.
Most people don't actually use that right to buy and sell the underlying stock or fund, mind you. Rather, they simply buy the option at a lower price and then sell it later at a higher price.
Here's the cool part about buying put options if you're expecting a sizable market correction: These trades can offset temporary lulls in your long-term holdings' values, allowing you to stick with them even when it gets a bit painful to do so. You also don't have to spend a ton of dough on a put option. In fact, the lower its price now, the more it gains in value should the market or a particular stock take a tumble. And if you're wrong about a market-wide sell-off being in the offing, it only costs you the price of the put options you bought. That's why you may as well keep them cheap.
Every trade has its downside, of course. The biggest downside of a put trade is that all options eventually expire. To make the most intelligent use of this strategy you have to have a handle on when a sell-off might start and stop. That's tough to do.
Still, I see this as a safer defensive strategy than inversely correlated (and often leveraged) ETFs like the Direxion Daily S&P 500 Bear 3X Shares. Leveraged inverse funds create a temptation to perfectly time an entry and an exit, but that flexibility seems to do investors more self-inflicted harm than good. With a cheap put option, you know going into it that it's only a short-term insurance policy. You're less tempted to treat it as anything other than that, even if you do fish around for the optimal exit point.
With all of that being said, if you're not already versed in option trading, first learning about them by using a put option to capitalize on a crash that may or may not happen isn't a great idea.
3. Keep it simple
David Butler: Avoiding losing money is just as crucial as making money when it comes to the prospect of getting rich. In the event of a market crash, it can be extremely tempting to look for the quick swing, buying highly volatile stocks on their fallout. Overall, it's far wiser to find great long-term investments at discounts to what they were asking.
These instances provide opportunities to create excellent gains, without taking on the risk of more speculative stocks. Look at the market crash of early 2020. Purchasing Bank of America back in April 2020 would have given you a nice 40% gain over the course of the next 10 months. In a relatively similar time span, General Motors produced gains of over 50%, without the risk of something like Fisker or Lordstown Motors. The beauty of a market crash or correction is it creates deals on quality stocks.
A name that we've seen a great deal of interest (and volatility) in has been AMC Entertainment Holdings (AMC 2.02%). Someone who bought this movie theater chain back when social distancing wrecked its revenue made good returns. I'm not just referring to the infamous Reddit fueled run of names like AMC and GameStop, either. AMC shares could be purchased for less than $3 in March of 2020, and were back at $5 by April. Here's the thing: The actual financial well-being of that company is much less clear.
It's important to do some research and find out if there's a genuine reason that stock fell so much. AMC Entertainment has taken a serious hit financially from the pandemic. Add in the fact that streaming has been threatening the industry for years, and there's a lot of risk here. If you want to get richer from market crashes, don't gamble too much on trades like this. That will minimize losses.
The second piece of the puzzle is making sure you have capital ready. Over the last five years, we've seen three significant corrections in the stock market. The only one that I'd go so far as to call a crash was our nightmare in early 2020. Given the increasing volatility of the market, investors are getting opportunities every few years to snag deals. Have the cash on hand to take advantage of it.