September served as a great reminder that stocks can go down as well as up. Although the market's approximately 4.7% decline (including dividends) for the month may have felt painful, the ugly truth is that stocks have crashed much harder in the past. The reality of investing is that you have to be willing to take the risks to achieve the long-term potential returns, and market crashes are part of those risks.
If concerns about market crashes are keeping up at night, you're not alone. Generally speaking, that's a good sign that your finances may not yet be adequately prepared to handle them. If you want to be able to ride out a real downturn, you need to be ready for it in advance. With that in mind, here are five ways to brace your portfolio for the inevitable.
No. 1: Have an emergency fund in cash
Especially in an environment where inflation is running above 5%, holding cash in a checking or savings account that's earning less than 1% in interest might seem silly. In reality, an emergency fund is one of the most powerful tools at your disposal when it comes to dealing with market crashes.
That's because stock market crashes and rising unemployment often go hand in hand. Without an emergency fund, if you find yourself jobless during a market crash, you could be forced to sell your stocks near the low just to cover your immediate costs of living.
Still, with cash providing returns well below inflation, it makes little sense to keep too much in cash. As a result, a reasonable guideline for an emergency fund is three to six months of expenses. That's a decent balance to cover your immediate needs and allow you some time to make adjustments without being so large that it provides a significant drag on your long-term financial returns.
No. 2: Keep money you know you'll need soon out of stocks
Whether you're retired, looking to buy a house or car, or have kids approaching college age, chances are you'll have costs coming up that are more than you can directly cover from your paycheck. Money you know you'll need to spend from your savings within the next five years does not belong in stocks. CDs or duration-matched Treasury or investment-grade bonds are a much better place for that kind of savings.
Your goal with that money should be to have what you need when you need it, so that you don't find yourself forced to sell your stocks near the low of a market crash. With those financial tools, you can often beat the return on cash, while still having the higher-certainty of those types of investments.
This is because it often takes years for the market to recover after a significant crash. With five years of money you'll need to spend from your savings held outside stocks, you'll have that much more flexibility to wait out a recovery without being forced to sell your stocks.
No. 3: Take your dividends as cash
In a rising market, it can be tempting to set your dividends to automatically reinvest to try to squeeze every last bit of return out of your money. If you're worried about a market crash, however, taking your dividends as cash could be one of the smartest moves you can make.
There are a couple of key reasons for this. First, dividends are typically paid based on the company's operational cash flows, not based on whatever its stock happens to be doing at the time. Seeing the dividend come in can serve as a good reminder that there's a business behind the stock and that the business is still delivering value. That can be helpful during a crash by keeping you focused on that value-generating ability instead of just the market movements.
Second, cash dividends give you a source of money to invest without having to sell your existing holdings or try to dig up dollars from some other place. That can give you the opportunity to be a buyer, rather than a seller, when the market is offering up its best values during a crash.
No. 4: Have a good sense of what your investments are really worth
When stocks are going up, it's easy to forget that they really just represent fractional ownership stakes in various companies. Successful companies generate money by selling their goods or services to their customers, and that generated cash provides the basis for what the business is worth.
With a valuation tool like the discounted cash flow model, you can get a decent handle on what a business is worth based on your projections for its ability to deliver cash for the future. Unless you have a working crystal ball, you'll never get it perfect, but you can often at least get a sense for whether it's trading for a bargain price or wildly overvalued.
During a market crash, strong companies often see their shares fall along with weaker ones. With the discounted cash flow model, you can help yourself find a sense for when that fall turns into an opportunity to buy shares of great companies for bargain prices.
Those chances rarely come along, but a market crash just might provide one. To take advantage of it, you need cash and the right mindset. The dividends from the above approach can give you cash, and the valuation model from this one can help provide the mental bulwark to enable you to buy while the market is melting down around you.
No. 5: Invest in stocks only with a long-term perspective
In a typical discounted cash flow model, projections for a company's future are broken apart into three time periods: near-term/fast growth, mid-term/moderate growth, and long-term/slow growth. When you do the math in the model, you'll often find that the long-term/slow growth period provides a huge part of the justification for the company's current value.
As a result, it always makes sense to take a step back and ask yourself whether you see that business still sticking around in that long-term future. Competitive disruptions, regulatory changes, and shifts in consumer preferences can all lead to cases where a once promising business evaporates. If you don't see a long-term future for the business, then it's probably not worth buying unless you want to try your hand as a cigar-butt investor.
It also means that you want to keep an eye out on a company's ability to innovate. If it innovates well enough, it might be able to continue growing faster than your long-term/slow-growth projection for a longer period of time than your model indicates. In that case, its value can continue to grow well beyond what your model says it will, potentially making your investment even better for the long run.
The best time to prepare for a crash is before it happens
Despite the downturn in September, the market is still close to its all-time high levels. That makes now a great time to prepare your portfolio for a market crash. After all, predicting that the market will crash is easy; knowing exactly when it will happen is the hard part. If you're ready in advance, then you'll be in a much better spot to ride out the crash and emerge stronger on the other side.
So get started now, and find yourself in a better spot when that next downturn inevitably occurs. Not only will your portfolio be better prepared for it, but you'll probably also sleep better at night, knowing that you're ready.