We never want to see the stock market crash, but it's always a good idea to prepare for the worst, especially when the market just keeps going up, up, and up. At some point we'll at least see a correction, but some experts think the inevitable rise of interest rates could create a massive drop in the markets, and some experts are even calling for a 60% crash.
While I personally think this is a little too dramatic, the reality remains that there really hasn't been a significant market drop in five years. So, let's take a look at a few rules that could help your portfolio survive whatever happens.
Get out of the high-risk, high-reward names...
When a correction or crash hits, the type of stocks that get the worst of it are high-volatility stocks. Some names that come to mind are Seagate Technology, First Solar, and Morgan Stanley, although there are tons of stocks that qualify. These companies certainly have fantastic long-term potential, but also have the most potential to lose money if things go bad.
To determine if you are vulnerable to huge price swings in a correction, one good metric to take a look at is the "beta" of the stocks you own. Most stock quotes you find, whether through your brokerage or through a website like Yahoo! Finance, put the stock's beta right on the quote page, so it's easy to find.
Basically, a stock's beta tells us how reactive it is to market swings. A beta of exactly 1.0 tells us that the stock should move right along with the S&P 500. If the index rises by 2%, so should the stock.
A beta of more than 1.0 tells us that a stock tends to react more violently to swings in the market. For example, if a stock has a beta of 2.0, and the market drops by 10%, you can expect about a 20% drop. Now, this isn't an exact science, and any company- or sector-specific events can move a stock no matter what the market is doing. For example, during the 2008-2009 crash, bank stocks were much more volatile than their betas might have indicated.
So, for those stocks I mentioned at the beginning of this section, a quick look reveals that Seagate has a beta of 2.5, First Solar's is 2.0, and Morgan Stanley's is 2.1. In other words, all of these stocks are at least twice as sensitive to market moves as the average S&P 500 stock.
...and buy some "boring" stocks
To best position yourself before a crash or correction, you want to be in low-beta stocks that pay dividends and also have a good record of raising the dividend. Companies like Procter & Gamble (0.4 beta) and Johnson & Johnson (0.6 beta) come to mind, as they have raised their dividend for 57 and 51 years, respectively. And for some more ideas, a great list of the best dividend growth stocks can be found here.
But won't these underperform when the market does well? Sure, but that doesn't matter too much. In fact, it's more important to outperform during the bad years. A stock that loses 33% during a bad year needs to gain 50% just to get back to even, while a stock that loses just 10% needs just an 11% gain to do the same.
Consider a simplified example of two investments, one high-beta, and one low-beta. The high-beta stock gains 20% during the good years, but loses 15% during bad years. And the low-beta stock gains just 12% during good years, but loses just 5% in bad years. For simplicity's sake, let's say that we have two good years, followed by two bad years, and then the cycle repeats.
Well, after 20 years, the low-beta stock will have delivered more than four times the gains of the high-beta stock. Of course, this is a very simplified example, but it's easy to see the effect that avoiding big losses, even at the expense of some big gains can have on your portfolio.
Doing well during the bad years can make you rich
The savviest investors know that outperforming the market during the bad years, even if you underperform when the market is up, can make a huge difference when all is said and done.
In fact, it is this principal that has allowed Warren Buffett to deliver his astonishing long-term performance, even though he regularly underperforms the market when the S&P rises by 15% or more. Over the past 50 years, the S&P has produced negative returns in 11 years, and Berkshire Hathaway's portfolio has outperformed the market during every single one.
So, if you're a little worried about jumping the gun and shifting your portfolio to "defense mode" too soon, don't be. Sure, if the S&P continues its rally and ends up hitting 2100 later this year, you'll probably lose out on some gains. However, when a correction does come (and it will, sooner or later), your defensive strategy will leave you in a much better position than those investors who stayed in the "it" stocks a little too long.