Economic and political uncertainty has made the market and many investors nervous. Daily market swings above 1% seem to have become commonplace, with five of the last seven trading days ending up with that type of volatility. In addition, longer term bond yields have been creeping up all year, raising the specter that inflation may be about to raise its ugly head.
In that type of environment, it's only natural to be worried that the stock market may crash. Indeed, the market will crash again; it's really only a question of when. To not just survive the next crash but thrive through it, you need to be prepared. If you're truly worried about a stock market crash, here are five ways to be ready.
1. Have an emergency fund
One of the big risks you face when the market crashes is that the stock market reflects investors' projections for the future of the overall economy. When the market crashes, it often means investors are getting nervous. That could turn into something of a self-fulfilling prophecy, where investors cut back on investing, which causes businesses to have less available to invest, which leads to job losses.
Having an emergency fund in place before the market crashes gives you much better flexibility to ride out those risks. If you lose your job while stocks are down, your bills will still be due. If needed, you can pay those bills with your emergency fund money and not have to sell your stocks to do so. It also gives you time to figure out ways to cut out as many costs as you can and flexibility to try to find a decent next job instead of just accepting the first role you're offered.
As a general rule of thumb, your emergency fund should cover between three and six months' worth of living expenses. If it's too small, it won't do you much good when things go wrong. If it's too large, then it can get in the way of your ability to invest for your longer term needs.
2. Be more conservative with the money for your nearer-term goals
Beyond emergencies, most of us have goals we're saving for. It could be a new house, a new car, college for the kids, a once-in-a-lifetime family vacation, retirement, or a whole host of other life priorities. As the time for those goals get closer, you should get the money for those goals out of stocks and into more conservative investments.
Money you expect to spend in the next five years does not belong in the stock market. Instead, consider cash, CDs, money market funds, or duration-matched Treasuries or investment grade bonds as the place to stash the money for those nearer term needs. In today's low interest rate environment, you won't get much (if any) return on that near-term money, but you will have a higher certainty that it will be available for you when you need it. That can make all the difference during a market crash.
3. Have a decent estimate of what your stocks are worth
Ultimately, a share of stock is nothing more than a small ownership stake in a company. While the market moves prices up and down on a daily basis, over the long haul, what drives the company's true value is its ability to generate cash and grow over time.
You won't get those estimates perfect, but you should be able to use that knowledge to get a reasonable handle on what your companies might truly be worth. That knowledge will help you when the market crashes. It will help you make more rational decisions on whether to sell, hold on, or buy more shares.
After all, if a crash knocks down a company's price to where it's a legitimate bargain based on its cash-generating abilities, then that might very well be a time to aggressively buy more shares. On the flip side, if a company's shares are down because its ability to generate money looks permanently damaged, then a declining share price might very well be a reason to sell. Either way, having that value estimate goes a long way toward helping you make a better decision on what to do when your stocks are down.
4. Turn off dividend reinvestment
When your companies pay dividends, those payments generally come in the form of cash. If you have dividend reinvestment turned on, then that cash gets used to buy more shares of the same stock that paid the dividend. In a declining market, you may not want to use that cash to buy more of the exact same company. Instead, you might want to either invest it in an even bigger bargain that the market throws your way or let the cash pile up to wait for that bargain to arrive.
Either way, having those dividends as cash gives you more control over what you do with it. In addition, seeing that cash pile up without having to sell anything to raise it could go a long way toward calming your nerves during a market swoon. So even if you aren't able to invest the cash from your dividends at the market's absolute bottom, that cash could at least provide some psychological boost.
5. Make sure your portfolio is diversified
Often, there is a key trigger that causes the market to fall -- such as the onset of the economic restrictions put in place to attempt to combat the COVID pandemic. While many companies may see their stocks drop during a general market panic, some companies are likely to be closer to the core of the drivers of that crash than others are. Companies that are the most affected may not recover at all, while those at the periphery may just be seeing their shares go on sale temporarily.
You usually can't tell in advance which companies will be at the epicenter of the next crash, so to protect your overall portfolio, you should diversify your holdings across industries. Diversification can't keep your investments from falling in a general market swoon, but it can limit your exposure to catastrophic, company-specific surprise failures. That can be the difference between some temporary financial pain and a permanent loss of capital.
If you're ready, a mere bear market won't scare you off
Whether we like it or not, bear markets are a part of investing. You can't eliminate them, and you can't always get out of their way before they affect your portfolio. What you can do, however, is make sure your portfolio and overall financial situation are prepared for them and thus you can boost your chances of making it through to the other side largely intact.
With these five ways to be ready, you can put yourself in a better spot to do just that. Still, they work better when they're put in place before the market crashes, so take advantage of the relative health of the current market to get yourself prepared. Even if the market's next crash doesn't come for a long while, you'll likely sleep and invest better knowing you're more prepared for when it does come.