Fears of a stock market crash have risen dramatically so far this year, as many believe that the nine-year bull run for stocks could be giving way to the next bear market. Yet even though recent events might make you question whether you have enough risk tolerance to deal with short-term market fluctuations, you can take steps to make sure that your portfolio will survive and thrive in the long run as long as you have a long-enough time horizon. In particular, using asset allocation strategies to diversify your portfolio and ensuring that you've rebalanced to adjust to changing market conditions can go a long way toward protecting your assets from a stock market crash. Here are some details on what most good financial advisors would suggest in dealing with the prospects for a future crash.
Having a solid asset allocation
Various types of investments react differently to stock market crashes, and having a mix of different asset classes can help reduce the impact of a crash. By choosing assets that won't go down as much as stocks in a crash, your overall losses will be less than they would've been if you'd had 100% of your investments in the stock market.
For instance, when stocks crash, the bond market often does well, with bond prices rising and yields dropping. During the last four months of 2008, the stock market fell 30%, but long-term bonds as measured by the iShares 20+ Year Treasury Bond ETF were up by 27%. That would've left an evenly split portfolio with minimal losses. Similarly, other assets like real estate and commodities can move independently of stocks during crashes. You won't always avoid losses entirely, but in the ideal situation, other investments don't lose as much as stocks and enable you to see less dramatic declines in your total portfolio value.
Part of the art of asset allocation is having the right balance of assets to meet your risk tolerance. If you're young and have decades to go before you'll need money for retirement and other long-term needs, then having a more aggressive allocation toward stocks is often best. You'll be vulnerable to crashes early in your career, but they'll actually be opportunities to invest further savings at lower prices and get potentially larger long-term returns. Those who are closer to retirement, however, need to consider more conservative mixes of assets because they don't have the time to recover from a major crash.
The biggest danger after a long bull market is that your current asset allocation can grow a lot riskier than where it started out. For instance, if you start with a 50/50 split and the stock market triples in price while your bond investments are worth the same as they were at the beginning, then your asset allocation will suddenly be 75% stocks and just 25% bonds. That's a lot more aggressive than you should be comfortable with, and if stocks crash, then a bigger portion of your assets than you expected will get affected.
To avoid that risk, rebalancing involves taking the asset class that's grown and selling off a portion of those assets, buying more in the asset class that hasn't grown as much. In the example above, you could take a third of your stock portfolio and buy bonds with it, restoring the 50/50 split. That has the downside of limiting your gains in a prolonged bull market, but the trade-off of safer portfolio performance is worth it -- especially for investors who will need to start taking withdrawals in the near future.
What real diversification looks like
Finally, it's important to understand what it means to be truly diversified. Some people make the mistake of just looking at the number of investments without examining what exactly they're investing in. For instance, if you own half a dozen stock mutual funds but they all hold the same stocks, then you're less diversified than someone who owns two funds that have completely different exposure. Similarly, if you own 10 stocks in your portfolio but all of them are technology stocks, you might have less protection from a crash than someone who owns five stocks that are all in different industries.
Real diversification involves looking at company size, industry, geography, and investment characteristics like dividends and valuation. You don't have to dip your toes into every single investment out there, but avoiding having just one big focus area could make a big difference in a market crash.
You never know when a stock market crash could happen, and once it begins, it's too late to make smart moves. If you think about these considerations and strategies before the market crashes, you'll be far better equipped to handle it and hopefully lessen the amount of losses you suffer as a result.