Stock market crashes can be scary because they can happen at any moment without warning. They can also result in huge losses in your investment portfolio in a very short period of time.
But they are normal, bound to happen, and can't be avoided. Instead of worrying, you can prepare yourself for one by doing these three things.
Image source: Getty Images.
1. Make sure you're not taking on too much risk
A stock market crash could result in your portfolio balance declining. But how you're invested could determine just how much it drops. Your asset allocation model is the percentage of stocks you have versus bonds. Stocks are considered riskier than bonds, so the more that are in your mix, the more you could lose.
If you're feeling nervous about a crash, adding safer investments to your accounts could help reduce losses. But the trade-off of lessening your risk is a hit to your return. And this type of move will also result in a lower percentage gain on average and during years when the stock market has a positive return.
And as tempting as it may be to lower your risk during a bear market and increase it during a bull market, this is market timing, which is incredibly hard. Guessing it wrong could result in you lowering your stock exposure too early or increasing it too late, causing inferior returns. That's why your best bet may be finding an asset allocation model that you feel happy with during all market cycles.
The table below shows how different asset allocation models would've performed on average during the Great Recession in 2008 as well as the following year when the stock market recovered.
| Asset Allocation | Average Rate of Return | 2008 Losses | 2009 Gains |
|---|---|---|---|
| 100% stocks | 10.3% | (37%) | 26.5% |
| 60% stocks, 40% bonds | 9.1% | (20.1%) | 18.3% |
| 40% stocks, 60% bonds | 8.2% | (1.7%) | 14.2% |
| 100% bonds | 6.1% | 5.2% | 5.9% |
Data source: Calculations by author.
2. Think long term
What are you using your money for? Seeing your account balance decline significantly is never easy, but it could be more devastating depending on how soon you need the money. If you're saving for something like your child's education in five years, a 40% loss could mean you can't pay tuition. But if it's for something like your retirement in 20 years, the threat is not as imminent and you will probably have time to recoup your losses.
It is for this reason that you should always consider your time horizon when investing. The longer you have until you need the money, the more aggressive your holdings can be, and the shorter the time period, the more conservative they should be. And money that you need over the next year or two should be kept out of the market completely.
For example, a $100,000 investment into large-cap stocks would've lost 43% of its value during the dot-com crash in the early 2000s, and been reduced to $57,000 by the end of 2002. It wouldn't have gotten back to its original value for five years. But by the end of 2020, 18 years later, it would be worth 354% more, despite losing another 37% in 2008. This is illustrated in the table below.
| Investment in 2002 | 5 Years Later | 10 Years Later | 15 Years Later | 18 Years Later |
|---|---|---|---|---|
| $57,000 | $104,000 | $113,000 | $235,000 | $354,000 |
Data source: Calculations by author.
3. Diversify your holdings
Adding different asset classes like bonds to an all-stock portfolio is one way that you can diversify your holdings. But you can also reduce your risk by adding different types of stocks or sectors. The stock market as a whole may suffer during a crash, but depending on the reason for the crash, certain industries may fare worse -- like tech stocks during the dot-com crash, real estate during the Great Recession, and hospitality stocks during the coronavirus crisis of 2020.
It could be hard knowing which industries, if any, will do worse. As a result, you could do really well if you have a lot of money in a sector that does well, but lose a lot if you invest most of your assets into one that does poorly.
That's why holding a broad range of different types of companies can help reduce concentration risk -- or having too many of your eggs in the same basket. The table below shows how individual sectors performed in 2020 compared to how a blended portfolio of all five would've done.
| Information Technology | Healthcare | Financial | Real Estate | Energy | Blended Return | |
|---|---|---|---|---|---|---|
| Rate of return | 43.6% | 13.3% | (1.7%) | (2.1%) | (32.5%) | 4.1% |
Data source: Calculations by author.
You may dread a stock market crash, but these fears won't stop one from happening eventually. Instead, you can better prepare yourself and your portfolio to withstand one. And while you can't stop all losses, you can find a level of losses that you feel comfortable with and that won't prevent you from reaching your goals.
