10 Things to Do to Prepare for a Market Crash

Fears that the coronavirus could dampen economic growth in the U.S. and around the globe have sent the market on a fairly sharp decline in recent weeks. Still, the market's decline could be much worse. Recall that when the dot.com bubble burst, the Nasdaq lost more than a third of its total market capitalization within a month.

On any given day, the stock market reflects the tension between investors' desires and expectations for the future and their fears that the future won't be as rosy as they hope. As long as that remains reality, crashes will be a part of investing. You can't eliminate them, and you can't really avoid them without also missing out on the market's upside in good times. What you can do is prepare for them so that you can ride them out. With that in mind, here are 10 things you can do to prepare for a market crash.

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When times are going well, it's easy to start treating your investments as if they were a savings account -- something you can simply tap for cash by selling shares if you need money quickly. When the market crashes, however, it suddenly gets far more expensive to convert shares of stock into cash. That leaves you in a lurch if you need the cash to cover your bills or an unexpected expense.

That's why having an emergency fund in cash is an incredibly important part of your financial plan. While keeping that cash in an actual savings account fund won't provide you a tremendously strong rate of return, it will provide you access to your money when you need it. That can help you avoid panic selling or forced selling after a crash to raise cash. That also allows you to stay invested, which is an important part of being able to take part in any recovery that follows.

ALSO READ: Emergency Funds Are Vital. Here's Why.

Because the market always has the potential to crash, you need to structure your finances in a way that you're not depending on your stocks to meet your near-term needs. As a result, a fairly standard rule in asset allocation is that money you expect to spend from your portfolio within the next five years or so does not belong in stocks.

Instead, cash, short term U.S. Treasury debt, or duration-matched investment-grade corporate bonds are much more appropriate places to stash the cash you'll need in the next five or so years. While you won't be earning tremendously strong rates of return on that money, you will have a much higher likelihood of that money being there when you need it. That can help you keep your head on straight and not make emotional decisions with the rest of your portfolio when the market turns against you.

The less money you need to cover your costs every month, the smaller the amount of your nest egg you need to cover that five-year buffer of cash or quality bonds. That means cutting your everyday costs helps you in a couple of ways. First, it means you have the potential to stretch that five-year buffer even farther, which means you can manage through an even longer downturn without being forced to sell.

Second, that money you free up from your everyday budget becomes money you can put towards rebuilding your nest egg. You can use that money to beef up your existing investments or stockpile it as cash to try and go bottom fishing if the market extends its downturn. Whatever you do with that money, having it gives you more flexibility and more options than spending it would. That can go far in helping you keep your wits about you while the rest of the market panics during an extended downturn.

Ultimately, a share of stock is nothing more than a small ownership stake in the business that sponsors it. That business will either make or lose money over time, and its earnings potential over time is what determines what that share is really worth. Unless you can predict the future, you won't know exactly what its future earnings look like until they happen, but you can certainly make educated estimates.

The point of your valuation estimates isn't to get it perfect -- it's to get your mind in a spot where you'll be better able to handle a market crash. If a company's stock falls far enough so that it becomes cheaper than what the company is really worth from a decent valuation estimate, then it becomes a candidate to buy more. Having that perspective will help you both during and after a market crash by reducing the urge to panic from the lower prices and increasing your willingness to buy while prices are low.

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As tempting as it may be to keep dividends on auto-reinvest in order to maximize compounding when times are good, collecting those payments as cash gives you opportunity during a market crash. Those dividends give you cash to invest -- cash you don't need to scare up out of your paycheck or raise by selling other investments.

Those dividends can be a ready source of money to invest in otherwise solid companies whose share prices have fallen into bargain basement territory due to that crash. In addition, if the market remains down for a long time, you can also start using those dividends as a source of cash to replenish your shorter-term money as you spend that to cover your costs.

ALSO READ: Worried the Coronavirus Is Ravaging Your Retirement Portfolio? Here's a Good Way to Compensate.

Some of the best features of dividends are the facts that they are controlled by the company's Board of Directors and that they are supportable by the health of the underlying business. What the market may think of the company's stock at the moment has very little at all to do with the company's ability to pay its shareholders cold, hard cash for the risks of owning those shares. As a result, you can tell a lot about the underlying health of a company by watching its dividend.

If a company raises its dividend even as its share price falls, it's generally a sign its leadership is confident about its future. On the flip side, if a company misses an expected dividend hike or even cuts its payment, it's a strong signal that the company's operations are struggling. Likewise, a company's dividend payout ratio will tell you how much of its earnings it is paying out. A low payout ratio combined with a high yield due to a falling stock price might even be a reason to consider buying more.

As the old saying goes, fortunes aren't made in bull markets -- that's just where they get revealed. The world's best investors build up cash when markets are booming and have that cash available to buy when markets are sinking and other investors are panicking. Indeed, the best times to "buy a dollar for fifty cents" or otherwise go bargain hunting in the stock market is when other investors are offering up incredible deals on their companies to get hold of your cash.

By investing when prices are low, you can buy more shares for the same dollar amount than when those prices are high. Once the market recovers, you'll still own those shares you bought cheaply, but they'll likely have a higher price tag attached to them. That's how bull markets reveal fortunes, by providing outsized rewards for investors who were willing to buy solid businesses when the market offered them at a deep discount.

If the market's recent gyrations have you worried to the point of inaction, there's a simple strategy you can use to help you get past it: make your retirement-focused investing automatic. Sign up for your 401(k) or other employer-sponsored retirement plan and have your contributions automatically withdrawn from your paycheck every payday.

A simple strategy of dollar cost averaging into an S&P 500 index fund allowed investors to have a positive total return during one of the worst decades the stock market has ever seen. If you sign up to fund your 401(k) every paycheck and have that money contributed to an S&P 500 index fund, that's exactly what you'll be doing. While it's not a guarantee of success, automatic investing does buy you more shares with the same dollar amounts when the market is low.

The unfortunate reality is that no matter what you do with your money, it's at risk. It's either at risk of losing purchasing power due to inflation or it's at risk of declines due to volatility and operating challenges among the companies you own. A key reason to keep money you need in the near term out of stocks is so that you can let the part of your portfolio that's in stocks ride the market's gyrations without being forced to sell.

If you've set yourself up with that split between long- and short-term money, then you have the opportunity to let your long-term money recover as the market does over time. It's important to remember that the market has seen drops before, and it will likely see drops again. While you can't avoid the drops, you can set yourself up to stay invested during them so that once the market recovers, you will still own those shares. And that's key to long term wealth creation from investing.

ALSO READ: The Power of Long-Term Investing in 1 Statistic

Buying stock using margin essentially means that you're borrowing money from your broker to make a purchase. You use that margin to create leverage in your account. Margin leverage brings with it two key problems for investors, particularly in a declining market. The first is that when your leveraged investment goes against you, you lose money faster than you would have had you owned that same investment without leverage. The second is that when you sign up to accept margin leverage at your broker, you also sign up to abide by your broker's leveraged investing rules.

Those rules usually include clauses that let your broker close out your positions if your equity falls too far. That could lead to a position where you're forced to sell due to a temporary swing in market prices, even if share prices recover shortly after that forced sale takes place. In other words, even if your investments may be winners over the long run, if you're leveraged, you may not be allowed to hold them that long. Being forced to sell low due to margin requirements is a great way to lose money.

5 Winning Stocks Under $49
We hear it over and over from investors, “I wish I had bought Amazon or Netflix when they were first recommended by the Motley Fool. I’d be sitting on a gold mine!” And it’s true. And while Amazon and Netflix have had a good run, we think these 5 other stocks are screaming buys. And you can buy them now for less than $49 a share! Simply click here to learn how to get your copy of “5 Growth Stocks Under $49” for FREE for a limited time only.

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