Given worries of a resurging COVID-19 threat, rising inflation, and stretched valuations have combined to make investors nervous about the stock market. The ugly reality is that the next stock market crash is inevitable -- the only real question is when that crash will happen.
Fortunately, market crashes are nothing new. Their history provides a great guide on how to not just survive the next one but also thrive when it comes time to emerge from the other side of it. The key is to get prepared before the crash so that when it comes, you have the tools you need already available to you. These four ways can help you be ready in advance.
No. 1: Raise the cash you need before the crash happens
With even top-rated savings accounts yielding well below inflation , it's really hard to hold a substantial amount of cash right now. Still, by making sure you have cash available before the next crash, you set yourself up to be much better situated after the crash happens.
There are a couple of key reasons for this. First, stock market crashes and job losses often go hand in hand with each other. If you lose your job after the market crashes, having a cash reserve can go a long way toward keeping you from having to sell near market lows.
Second, if you have cash available, buying stocks after they've crashed is a great way to make your money work harder for you. Selling one cheap stock after a crash to buy another doesn't make all that much sense, but raising cash when stocks are pricy to invest when they're cheap can be a much smarter wealth building strategy.
The key trade-off, of course, is that money you have set aside in cash isn't earning much in the way of a return at the moment, especially when compared to inflation. A good rule of thumb is that you need at least a 3-6 month emergency fund in cash. In addition, having around 5 or so years' worth of expenses you need your portfolio to cover in a less volatile and higher certainty investment than stocks can help you ride out typical downturns.
No. 2: Know the value of what you own
Ultimately, a share of stock is nothing more than a fractional ownership stake in a business. A reasonable value can be estimated for most companies by using techniques like the discounted cash flow model to assess the current value of its expected future earnings stream. In a rapidly rising market, relying on valuations can seem old school, but when the market is crashing, valuation plays a much bigger role.
A key reason is this: if you can buy a company for a reasonable or even cheap price based on its ability to generate cold hard cash, why would you sell just because the market is panicking? Indeed, a discounted cash flow analysis or other fundamentals-based valuation technique can help the savviest investors know why it's OK to buy more shares even as the market is collapsing.
Beyond that, understanding what a company is really worth can help you prepare for a crash. If a stock you own has risen to the point where there is absolutely no financial justification for its market price, it might be a good candidate to sell to raise the cash you need.
No. 3: Have a shopping list of companies you want to buy
Even the best investors can feel overwhelmed as the market moves swiftly and strongly against them. That's where having a plan for what you'd like to buy -- and at what price -- can come in handy. With a list of great companies and a reasonable valuation estimate for each of them, a market crash can turn into an incredible buying opportunity to buy their stocks while they're on sale.
Of course, you do need to keep in mind that the market often has a good reason for crashing in the first place. As a result, when the market offers you what looks like a great price to buy a company you're interested in owning, do take a moment to refresh your estimate of the company's value before buying. If the company's shares tanked because its business is failing, it's probably not worth owning. If its stock was unfairly discarded in a general market panic, however, it could be a great time to buy in big.
No. 4: Keep smartly diversified
Often, when the overall market crashes, it's because an entire industry finds itself in trouble. For instance, consider the dot.com implosion in 2000 or the financial crisis in 2008. If a big chunk of your money is chasing the next hot thing and that particular thing is what drives the next market crash, then you can be in a world of hurt. If the companies you own wind up out of business, then their shares -- and the money you have invested in them -- won't be participating in any rally that follows.
When times are good, portfolio diversification may seem like a fairly meaningless exercise. After all, it can't help you earn better returns in a raging bull market. When the market is in a panic, however, there is incredible value in its ability to limit the impact that any one company or industry's failing will have on your overall net worth. After all, limiting the unrecoverable damage of a crash is key to being able to participate in any subsequent recovery.
You can make it through the next crash
Stock market crashes are inevitable. There's not much you can do to avoid them aside from not investing at all, and that can be incredibly hazardous to your long term net worth. With these four approaches, you can improve your odds of making it through the next crash intact and potentially even emerging in a better position once it ends.
The key thing to note about these techniques, though, is that they work better if you get them in place before the next crash happens. So if you're really worried about a market crash, then there's no better than when the market is near an all-time high to get your plans in place.