The stock market has reached a fever pitch, leading a lot of people to worry that a crash is coming. Spoiler: Another stock market crash is inevitable, and it's completely normal. On average, the stock market undergoes a correction (defined as a drop of 10% or more) about once every two years.
You may be tempted to hoard cash in order to prepare. But typically, dollar-cost averaging is the strategy that produces the best results for investors. Basically, you budget a certain amount to invest each week or each month and invest regardless of what's happening in the stock market. Over time, this tends to lower your investment costs.
But there are a few times it makes sense to prepare for a bear market by hoarding cash. Here are three examples.
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1. You want to invest more after a crash
If you're planning to use a stock market crash strategically to buy more shares, building extra cash reserves makes sense. A good solution here is to continue dollar-cost averaging, particularly in your retirement accounts. But you can sock away extra money in your savings account so you can pounce on a few bargains after a crash.
Just be sure that you have a strategy if you're using this approach. For example, you could decide that you'll invest an extra $1,000 in an index fund for each 5% drop in the S&P 500 index. Or you could make a stock watch list and decide the price you're willing to pay ahead of time.
Making these decisions before the market tanks helps you avoid emotionally charged decisions -- people don't always react the way they think they will after seeing their net worth temporarily tank. On the flip side, you don't want FOMO (fear of missing out) to tempt you into jumping into highly risky investments.
2. You're building an emergency fund
Your emergency fund is your best defense against losing money in the stock market. Imagine if you had to raid your retirement accounts in March 2020 when the market reached bottom. Not only would you have had to sell when the market was down more than 30%, but you also would have likely been hit with taxes and penalties for cashing out early if you were younger than 59 1/2 at the time.
Focus on building your savings balance even before investing if you don't have at least three months' worth of expenses stored safely in your bank account. Once you've reached three months' worth, you can split your extra cash between investing and working toward a six-month emergency fund, which is your ultimate goal.
3. You're planning to retire soon
A prolonged bear market can devastate even the best-laid retirement plans. So if you're approaching retirement, you'll want to have significantly more cash on hand than you would if retirement were decades away.
Aim to have at least one to two years' cash on hand. That way, you can minimize your retirement withdrawals when the market is down and give your investments time to recover.
But don't delay. If you need to cash out some of your portfolio, it's essential that you do so while stocks are still surging instead of waiting until the damage has been done.
