Stock market crashes can be scary, but they are a normal part of an investment cycle. Predicting when one will happen is difficult and even savvy financial experts can get it wrong.
If you're invested for the long term, avoiding one completely will probably be impossible. But no matter when the next one happens, implementing these four lessons can help make sure you come out on top.
1. Timing the market can cost you money
Whether you're selling investments or buying new ones, timing the market can cost you if you don't guess correctly. If you sell stocks thinking that there will be a long-lasting decline, a quick recovery could be missed. Many investors and investing gurus believed that the losses experienced in March 2020 because of COVID-19 fears were just the beginning.
If you were someone who sold out of your stocks to get ahead of these losses, you could've missed a v-shaped recovery followed by a year of positive stock performance. How much would've depended on how long your accounts stayed uninvested.
Between Jan. 2, 2020, and March 23, 2020, the S&P 500 declined from 3,245 to 2,237 and lost 31% of its value. Within four months of March lows, this index was in slightly positive territory and closed at 3,257 on June 21, 2020. By year-end, it closed at 3,732 -- 15% higher than where it started.
If you were someone who kept cash uninvested during this same time period because you were fearful of further declines, you would've missed out on 45% worth of gains from the market bottom to the end-of-year close.
2. Emergency funds are crucial
If you've invested money that you could potentially need soon, a decline in value could be a threat to your livelihood. One way you can solve this issue is by making sure you have an adequate emergency fund -- one that will get you through a period of lost income. A good emergency fund should cover at least six months of your monthly expenses. But the coronavirus pandemic has taught us that you might need them covered for even longer.
If you have extra money that you can spare, you can build your emergency fund with these savings. If your budget needs to be reworked so that you can meet this objective, there are several ways you can accomplish it. You can temporarily direct money from another savings goal into it, or you can eliminate unnecessary expenses until this account has a balance that you believe is sufficient.
3. Market corrections can be great opportunities
If you are in a financially stable position, a bear market can be a great investment opportunity. If you have a lump sum of money, you can buy your holdings for less when the prices drop. If you feel uncomfortable about putting a large amount of money in not knowing if the stock market could decline further, you can use a dollar-cost averaging strategy during this period of uncertainty.
With this method, you'll invest a pre-determined amount of money into your portfolio each month. You'll get some prices that are higher, and some that are lower. You'll also get the peace of mind that you're not making a big investment decision at the wrong time while getting off the sidelines and investing for your future.
4. Asset allocation and diversification can help you avoid losses
The more concentrated you are in a particular stock, sector, or asset class, the more your accounts could lose from year to year. For example, real estate lost 9% in 2020. If you had an overweight position in this category, you could've ended the year in the red. Investment-grade bonds earned 7.5%. If you moved all of your money to this asset class so that you could avoid stock market losses, you would've underperformed large-cap stocks, which finished out the year at 18.4%.
Although the year played out this way, it could've gone differently. If experts had been right and stocks had performed badly, owning bonds and real estate could've worked out in your favor. Because you don't know what will do well and what won't, diversifying and owning a little bit of everything can help you avoid this guessing game.
When you invest, there will be some years that your accounts grow, some when they end up flat, and some when you lose money. As great as avoiding losses altogether would be, it's probably not realistic. And attempts at avoiding them might come at the cost of missing out on positive returns as well. Instead, adopting an investment philosophy that limits your losses during these times and lets you capture some of the benefits could make you an even more successful investor.