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Don't Worry About the Next Drop -- Plan for It

By Jim Mueller, CFA - Mar 27, 2015 at 3:29PM

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Four simple steps you can take to prepare for the next stock market drop.

This commentary originally appeared in slightly different form in Motley Fool Supernova.

I was reading one of Morgan Housel's recent articles when I ran across this:

Stocks fell almost 20% in late 2011. Do you remember it anymore? Probably not. Are you scared of the next 20% crash? Probably. Think about that.

Here's the chart of the S&P 500 for the period Morgan was writing about:

Screenshot image taken from Yahoo Finance.

Between July 22 and Aug. 8 -- that big drop -- the S&P 500 fell 16.8%. It reached a bottom on Oct. 3, down 18.3%.

This happened just a few years after the financial crisis, and it probably caused a great deal of anxiety. Yet as I write this, the S&P 500 is hovering near 2,100, about 55% higher than it was that late-July afternoon (and about 90% higher than the October bottom!).

Are you worried about the next 20% drop? Should you be?

If more investors just sat on their butts rather than worrying about the next big drop -- or even freshened up their watch lists with great companies to invest in -- they'd be richer (and calmer) than if they spent all their time worrying and trying to get out ahead of the crash, whenever it may come.

Yet doing that is really, really hard, which is probably why so many people don't.

So what can you do to prepare for the next crash? 'Cause sure as sunrise, it will happen.

First, don't invest money you'll need within the next three to five years. Any cash you need to pay for a vacation or buy a car or simply live on should not be in the market. If you are living off your investments, rather than a ready cash supply, then you're exposed to the risk of having to sell at the worst possible time just to raise the money to keep body and soul together.

Second, consider building up a small(ish) cash cushion inside the portfolio. People sometimes call this "dry powder" because you'll want to be ready for action when a compelling buying opportunity comes along. A cash position that's 5% to 10% of your portfolio shouldn't be enough to significantly drag down your returns, and you'll get a bit of a buffer when prices start to tumble. Note: This is a separate bucket from the cash set aside for shorter-term spending, described above.

If you don't want to hold that much cash, make a list of companies you'd sell from your portfolio to raise the money needed when a new opportunity presents itself.

Third, create a watch list of stocks you'd like to buy -- at the right price. These could be companies new to your portfolio or ones you already own, but the idea is that you already know them and wouldn't have to do much research if the price dropped down to your hoped-for level.

And finally, do this before the market makes its next drop. If you're fully invested, consider lightening up on a couple of your winners (which might be starting to dominate your portfolio) or trim away some of the losers to raise cash. If you wait to do this until the market is declining, then you'll be competing with other investors trying to sell at the same time. Plus, you'll be under the stress of your emotions telling you to sell everything right now, meaning you might end up selling something in the heat of the moment that you later come to regret. Plus, you won't be scrambling to figure out what to buy (and fighting your emotions at the same time).

In other words, be like a boy scout and "be prepared" ahead of time with a watch list and previously set-aside cash.

By taking these simple steps, you'll feel better knowing you have a plan of action for the next market drop, and you'll be able to act more rationally than others, having thought things through ahead of time. That alone will give you an advantage.

With that done, you can lean back and successfully practice sit-on-your-butt investing, knowing you'll be ready to move when the time is right.

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