The stock market dipped in the first quarter of 2022, and investors are worried that a market crash could be around the corner. That's certainly a potential risk, but it's anyone's guess where the market goes from here. If you're worried that stocks will continue to fall after a rough start to the year, you should take a few steps to protect your portfolio and invest stress-free.
1. Do some mental preparation
The most important step in preparing for a market crash has nothing to do with trades or portfolio allocation. Investors can drastically improve their long-term results by preparing themselves mentally and emotionally for volatility.
Investors need to recognize that periodic volatility is inevitable in the stock market. Equities can provide phenomenal growth opportunities. As the global economy expands, corporate sales and profits rise. In the long term, stock valuations are based on the cash flow of the underlying company. However, stock prices are determined by the supply and demand in the open market. That can lead to significant gains or losses in the short term.
You should be at peace with this fact before committing capital to the stock market. When the stock market starts falling, you can't give in to panic and fear. Don't shoot yourself in the foot by abandoning your strategy and selling stocks that are down. The best move is to plan for long-term gains and remain calm during short-term disturbances. That's absolutely a challenge, so keep that historical perspective during market downturns. Every crash has been followed by a larger recovery.
2. Take a risk-tolerance questionnaire
A questionnaire isn't a magic trick that can save your investment portfolio during uncertain times. However, it's an important first step toward a sound investment strategy. Everyone should try this -- especially those who worry about volatility.
Portfolio allocation is difficult. Even if you know what investments to hold, it's tough to know how to balance those holdings. Luckily, time-tested methods can translate your investment goals and needs into a target asset allocation. You can get a risk-tolerance score based on your emotional reaction to losses, investment time horizon, and other factors.
That risk score can tell you how to allocate your investment among stocks, bonds, and cash. It can also help you determine how to deploy capital across different types of stocks. Once you're armed with this information, you'll know whether or not you're prepared for volatility. If you're too exposed to risk, you can buy lower-risk assets. If your allocation is already optimal, you don't need to change anything.
3. Re-allocate to low-volatility assets
At the end of a bull market, many investors are too heavily exposed to risky growth assets. Many people got carried away with greed and optimism and piled into stocks. Even if you didn't switch your strategy as the market rose, the strong performance of stocks probably skewed your allocation from its previous balance. This could be a good time to review your portfolio weighting and rebalance it.
Bonds and cash are the most popular asset classes for reducing volatility. These can fluctuate in value, but they typically don't change as drastically as stocks. If the market crashes, your losses will be reduced by holding bonds or cash. Moreover, you'll have more capital to buy stocks at a discount after the market drops.
Don't go overboard with this. The current downturn might not turn into a crash, and recovery could be around the corner. You don't want to sabotage yourself by leaving the market and missing out on growth.
4. Buy dividend stocks
In recent months, investors have seen capital flow out of growth stocks and into value stocks. They are leaving stocks with aggressive valuations, and cheaper stocks are becoming more valuable.
During market crashes, dividend stocks tend to perform well. These are usually companies with relatively predictable cash flow. They are often mature and stable businesses. By investing in these companies, you can enjoy returns through regular dividends, even during crashes. If you can tread water as the market bottoms and recovers, then you don't have to sell stocks at a loss. Meanwhile, you can achieve investment growth through dividends. If you're retired, you can use those shareholder distributions as income to support your lifestyle.
Dividend stocks will almost certainly drop if there's a market crash, but they will be relatively strong performers even in bad times.
5. Consider hedging
Most investors don't need to hedge, especially long-term investors who are prepared for volatility. However, there are hedging strategies for more sophisticated investors who can't endure short-term disruptions.
Short trades, inverse ETFs, and options are popular methods to capitalize on a market crash. The value of these positions can rise when stocks fall. They aren't meant to make up a large portion of a portfolio. Instead, they are designed to partially offset the short-term losses incurred in an otherwise long-term investment strategy. Some cavalier investors will use hedging instruments more aggressively, but those are exceptionally high-risk strategies.
In general, most investors should be hesitant to get involved with hedging. If you're determined to hedge, make sure that you're ready for the risks and responsibility of these strategies.