After nine years of an explosive bull market run that has made Pamplona look like the Westminster dog show by comparison, investors have become a lot more afraid that a stock market crash could be right around the corner. A combination of political and economic issues has increased volatility in the markets and could set the stage for a major pullback for the Dow Jones Industrials (^DJI -0.11%) and S&P 500 (^GSPC -0.54%) from their recent record highs.
While it won't necessarily be as bad as what investors suffered in 2008 and early 2009, a future crash will test the resolve of millions of investors fearing the worst-case scenario for their retirement savings. The smart thing to do is to prepare during good times for the devastating market moves that could occur, and the following three things are worth thinking about as you plan your risk management strategy.
1. Be ready for the market crash before it happens
Investors should always have a potential crash in mind when they put together their investing strategy. That doesn't mean being unnecessarily conservative with your investments, but it does mean choosing an overall strategy that takes into account what they'll do in the event of a major downturn.
Those who have decades to go before they need the money they're saving can afford to weather market crashes without really taking much action in their portfolios. In fact, if you're just starting out, then you should actually welcome a crash, because it lets you invest future savings at much more favorable valuations. You'll be able to buy more shares of stocks or funds with the same dollar amount after a crash, increasing your future growth potential.
If you're closer to retirement and have less time to recover from a crash, then looking at your asset allocation is important to ensure that you're comfortable with the level of risk in your portfolio. You generally shouldn't give up on stocks entirely, but reducing allocations can be a smart move. In particular, if the share of risky investments like stocks has risen because of gains you've earned during the bull market, then moving a portion of your portfolio out of stocks into safer investments can reduce your overall potential risk before the bottom falls out of the market.
2. During the crash, don't do a thing
More investing mistakes happen during market crashes than at any other time. Panicked investors sell off their holdings at the worst possible time, fearing that even bigger losses are right around the corner. Inevitably, they choose the bottom of the market crash to sell and then face a dilemma: Do they buy back at higher prices or stay out of the market and miss out on long-term growth? Neither is ideal, but there are many investors who sold at the lows in the market crash almost a decade ago and have never gotten back in -- missing out on huge gains.
Ideally, you'll have things set up so that you'll continue to make regular investments to take advantage of low prices during a crash. Letting that happen automatically is a great way to benefit from the crash, and it prevents your emotions from getting in the way of good judgment. Other than that, you should generally make no changes and trust your strategy to work.
3. After the crash, assess the situation
After waiting an appropriate length of time to let your emotions calm down, look at how your portfolio performed and see what worked and didn't work. If some of your investments didn't do what you thought they should do in a crash, then it's worth looking at whether you need to replace them with better investment options. For example, some people look to certain types of stock mutual funds as being less vulnerable to a crash, but if that didn't pan out the way you expected, you might prefer to look for better alternatives going forward.
Don't be in a rush, however, to make major structural changes to your investing strategy. One way you can make gradual changes is to keep your existing assets as they're invested but to direct new contributions into different investment options. That way, you'll gradually pivot toward the new strategy but allow your old investments to possibly recover some of their losses. Going forward, the shift to new strategic thinking should bring you closer to where you're comfortable in handling potential future crashes.
Having a plan in place beforehand for a stock market crash is a great way to take panic out of the discussion. That way, you'll know what to do when the crash happens and avoid many of the mistakes that devastate other investors during tough times for the markets.