With the Federal Reserve finally getting serious about addressing inflation, there's a real chance that the stock market could crash again. After all, if interest rates go up and the money supply contracts, borrowers will have to pay more and lenders will get more for loans. That makes lending more attractive for investors and leaves less money available for stocks.
If you're an investor, you need to recognize that risk and prepare yourself for what could very well be rocky times ahead in the market. If you're smart about it, you can do that without abandoning the long-term growth potential that stocks provide. With that in mind, these four ways to brace your portfolio to sleep easy in a market crash can help you get through the rocky investing seas we could very well be facing soon.
No. 1: Get your debts under control
It's perfectly OK to invest when you have debt that is in control. If your debt is at a fixed and low rate, is easily coverable by your cash flow, and serves a purpose that helps make your future better, then it's in control. If your debt doesn't meet all those criteria, now is a great time to get it to where it does. The overall stock market isn't all that far off its highs, and with the Federal Reserve broadcasting aggressive tightening, the window to get your debts in control may be closing quickly.
Paying off or refinancing your not-in-control debt will help you in a number of ways. First and most obviously, if rising rates force your debt payments higher, that directly takes more money out of your pocket. On a related note, if rising rates cause the stock market to fall, you'll get that much more upset with yourself for not selling to get your debts under control when you could.
In addition, it's never fun to see your stock portfolio fall. It can get quite difficult to hold on during tough markets, even if holding on would give you the best chance of participating in any recovery that follows. That urge to panic sell that often comes with a falling market will only be magnified if you're worried about covering your bills or your debts with less money available to you.
No. 2: Have a reasonable emergency fund
Typical financial guidance indicates that you should have a three-to-six month emergency fund available to you in something as risk-averse and as easy to tap as a savings account. This is important if the market crashes because market crashes and job losses often go hand in hand.
An emergency fund gives you a buffer to help you get through the initial shock of job loss without being forced to immediately sell your stocks to cover your costs. It also gives you a little bit of flexibility in the event you find yourself with a lower income while the economy goes through a rough patch.
The trade-off, of course, is that in today's low interest rate and high inflation environment, the money in your emergency fund will be losing ground in real terms over time. As a result, as important as an emergency fund is to protecting your portfolio in a market crash, you don't want to overdo it. That's what makes a three- to six-month timeframe work well.
No. 3: Keep money you know you'll need to spend soon out of stocks
Money you need within the next five or so years does not belong in stocks. This is because once the market crashes, it might take years to recover. As a result, if you know you will need money from your portfolio within the next five years, it should be in something more conservative than stocks. That means things like CDs, cash, or duration-matched investment-grade or Treasury bonds.
This does mean that you likely won't see much a return on that money, but chances are better that the money you'll need will be there when you need it, even if the market turns sour. This is particularly important if the market crashes, as you'd otherwise have to either sell more shares or do without whatever it was that you were hoping to buy with that money.
No. 4: Know the value of what you own
Ultimately, a share of stock is nothing more than an ownership stake in a company. That makes it possible to get an estimate of what those shares are worth by considering how much money the company will likely make over time.
Using a method known as the discounted cash flow model, you project out the company's future earnings. Then you back down the value of those future potential earnings because money that might be in your hands in the future is worth less than the same amount of money that is certainly in your hands today. The result of that work is your estimate of what the company behind that stock is worth today.
Although it isn't perfect -- you are guessing about the future, after all -- it can often get you in the ballpark of a fair value estimate of what a business is worth. This can help in a crash because when a strong business sees its stock drop along with the market, it can enable you as an investor recognize an opportunity to buy at a bargain price. That can make a substantial difference, as you can buy more shares for the same number of dollars when they're cheap, which can really accelerate a recovery.
Get started now
These four approaches can help you brace your portfolio to allow you to sleep easy in a market crash, but they all work best if you put them in place before a crash happens. With the market still hovering near its recent highs, now might be a great time to get your finances ready.
If a crash happens soon, you'll certainly be glad you did. If it doesn't, you can still rest easier knowing that the moves you made are ones that make sense even in a normal market and that still set you up well whenever the next crash happens. That makes it a win-win worth making a reality quickly. So get started now, and position yourself to sleep better at night the next time the market crashes.