Prepare for the Crash

The stock market crash after the Internet bubble destroyed portfolios -- and dreams. The Nasdaq fell from 5,000 to below 1,200 -- nearly an 80% decline. And that's only an average. Many stocks became essentially worthless. The tragedy wasn't in the numbers, though -- it was in the effect those losses had on people. Many investors were completely wiped out, losing money they'd been saving for years.

This really isn't the sort of pain you want to experience firsthand. That's why it makes sense for all investors to have a portfolio that is prepared for lean times. If a terrible day ever comes, you'll want to make sure you suffer only a flesh wound, not decapitation.

At Motley Fool Inside Value, we specialize in identifying stocks that not only outperform on the upside but also can survive a crash relatively unscathed.

Diversify now
Investors with technology-focused portfolios suffered the most a few years ago. There was almost nowhere in the sector to hide, with even the strongest companies suffering huge declines. Nokia (NYSE:NOK) fell more than 75%, while CA (NYSE:CA) dropped 85%. Even now, these companies aren't close to their pre-bubble highs. And again, these are some of the strongest companies in the sector.

The moral of the story isn't that technology companies are risky but rather that diversification is a key component of a crash-resistant portfolio. While tech has been dreadful, the Vanguard REIT Index would have nearly tripled your money since 2000, and energy stocks have had outstanding returns as well. A diversified portfolio that included technology, real estate investment trusts, and oil would have prospered. Diversification also ensures that you get the full benefit of your stock-selection skills. The crash demonstrated that it's no condolence to identify the best-performing stocks in the worst-performing sector. Being the best of the losers doesn't make you a winner. But if you pick the best of each sector, you'll do quite well.

Buy cash
The problem with the companies that fell the most when the bubble burst was that they had neat ideas but didn't actually make any money. Even some of the most popular companies had this problem, such as Vignette (NASDAQ:VIGN). Before the crash, Vignette was drowning in red ink, having never had a profitable year. But investors assumed that it would be a great investment because of its products targeting the hot Web applications niche. That was a costly mistake.

Unprofitable companies have little flexibility in bad business climates and tend to do poorly in bear markets. In a panic, investors aren't buying dreams. They're sticking with consistent cash machines, such as steady blue chips Altria (NYSE:MO) and Caterpillar (NYSE:CAT). It's no coincidence that these two companies show spectacular long-term returns, unfazed by the recent bear market. Businesses that earn gobs of cash don't have to raise money to survive. They can even take advantage of poor conditions to gain market share from weaker competitors. These businesses tend to be crash-resistant.

Be skeptical
One of the best ways to guard your portfolio against a market crash is by maintaining a healthy level of skepticism. Wall Street isn't a charity; it's a bunch of businesses focused on making money for themselves. Helping small investors make a profit is item No. 382 on the list of Wall Street priorities, falling immediately below ensuring that the new assistant knows exactly the right amount of milk and sugar to put in everyone's morning coffee.

Be skeptical of analyst forecasts, whether it's a prediction that oil will hit $110 a barrel or that Internet Capital Group (NASDAQ:ICGE) will break $250 (pre-reverse split). While Internet Capital Group's price targets were trumpeted on TV before the crash, I haven't seen many apologies for the stock's subsequent performance. It's now trading at prices that are a mere fraction of the targets set back then.

Rather than blindly trusting the analysts, make sure you understand the companies you're buying. Understand what risks each business faces and what competitive advantages will help the company overcome hurdles. Be particularly wary of high growth estimates, because analysts tend to be optimistic, and high growth is difficult to sustain. If the company fails to achieve overly ambitious growth estimates, the stock will be hammered. Finally, buy a stock only if, after conservative analysis, the company is trading at a bargain price. Stocks tend to return to their intrinsic values, so buying below that value provides significant protection in a crash.

We follow these techniques at Inside Value by performing our own research, starting with a thorough understanding of the company. As part of each recommendation, we not only describe what the company does but also discuss the competitive landscape and possible risks. Finally, we recommend only stocks that are trading at dirt-cheap prices.

Foolish final word
While a crash will hurt any portfolio, a few carefully chosen strategies can help you avoid the worst and give you the opportunity for big gains along the way. If you're interested in reading our recommendations, we offer a free, no-risk 30-day trial, which gives you access to all issues, a discounted cash flow calculator, and dedicated discussion boards.

Whatever you do, start planning your blueprint for a bear-resistant portfolio.

This article was originally published Sept. 28, 2005. It has been updated.

Fool contributor Richard Gibbons is scared of stock market crashes, large flying objects, and eerie music. He does not own shares of any of the companies mentioned in this article. The Motley Fool has a disclosure policy.