Despite the incredible bull market run we've had in the 10 years since "the lost decade" ended, stocks don't always go up. Indeed, as that lost decade reminds us, they can go down and stay down for years, particularly if they start from a place of stretched valuations and very high expectations.
While it's never fun to think about a market crash, the time to plan for one is when stocks are regularly reaching new highs. After all, that's when you have the most assets at your disposal to convert from wealth earning to wealth protecting ones. Not only that, but you can also make the switch by selling the fewest shares while prices are high, making it an efficient time to do so. With that in mind, here are three tips on how to prepare for a crashing market.
1. Set aside money you'll need within five years
One of the most important rules of asset allocation is that money you need to spend from your portfolio within the next five years does not belong in stocks. If you've been neglecting that rule during the bull market, now is a great time to bring it front and center and convert enough to cash or duration-matched investment grade bonds to reach that threshold.
Note that this doesn't mean you need five years' worth of your total costs of living in cash or those bonds. If you've got income from another source, like a job, a pension, or Social Security, those income sources cover some of your expenses, so you don't need your portfolio to cover those. But if you were planning on selling stocks to buy a car, help a child with college expenses, or otherwise spend down some of your assets in the next five years, now is a great time to get that money out of stocks.
2. Assess your stocks based on their long-term potential
Ultimately, stocks are nothing more than financial assets that represent ownership stakes in the companies that offer them. Over time, the value of a company's stock is based on the market's expectation for its cash flows between now and when the business eventually closes its doors for the last time. On a day-by-day basis, however, there's no guarantee that the market's price is anywhere near that fair value for the company. That's where your opportunity comes from.
After a massive market run up, there's a great chance that at least some of your holdings aren't really worth as much as the market is offering you for them. If you can identify the ones that are way overpriced relative to their long run cash generating potential, you can sell them and collect more cash of your own than you otherwise would have. That's both a great way to generate the cash for your near-term spending needs and to assure you have cash available to buy bargains when the market does fall.
3. Let your dividends tell you about the health of the company
In addition to the cold, hard cash they provide, a company's dividends can tell you a lot about what's really happening to the company's fundamentals, regardless of what its share price is doing. A company's dividend payout ratio will tell you how much it's earning compared with what you're getting paid. A low payout ratio combined with a high dividend yield usually indicates that the underlying business is much stronger than the market is giving it credit for.
Similarly, since a company pays its dividend based on its cash generating ability, it is quite possible for a business to increase its dividend even as its share price falls through the floor. That's more cash for its investors -- cash they get without having to sell those shares while they're down. A rising dividend combined with a falling stock just might even be a reason to consider buying more shares. Conveniently, that dividend even provides some ready cash to help make that type of purchase a reality.
Prepare now and eliminate the panic later
It's not a question of whether the market will crash; it's only a question of when. This deep into the incredible bull market we've had this past decade, you probably are in a better position to prepare for that crash than you have been previously. That makes now a great time to get ready for the crash.
As these three tips show, preparing for the inevitable crash doesn't have to be a particularly painful, if you do it now, before the market falls. Wait until after a crash takes place to make your adjustments, and you'll find that it'll be a much more painful and expensive move to make.