These 4 Steps Will Save You In The Upcoming Market Crash

April 18, 2018

These 4 Steps Will Save You In The Upcoming Market Crash

A stock market crash is always around the corner.

In the last 18 years, we’ve seen two crashes of 50% and if you live in the Netherlands, you still dream of those 2000 highs. Nevertheless, a 9-year bull market quickly erases all the painful memories.

But forgetting what happened and how it looked is dangerous. If you haven’t lived through a stock market crash, you should at least try and think about it in order to be prepared as much as you can be.



What People Forget About 2009

Today many look at 2009 with little concern, at least those who weren’t severely affected by it do.

Figure 1: 2009 stock market crash. Source: FRED.

However, look at how quickly stocks dropped. In the first months of 2009, a lot of investors capitulated and sold because they couldn’t watch their savings disappear day-by-day.

The DJIA fell below 10,000 points and when it was around 7,000, many thought it would go to 5,000.

Figure 2: Wall Street Journal (WSJ) article from March 5, 2009. Source: WSJ.

Imagine being there in February of 2009. You’ve just experienced a 40% drop and there was no end in sight. The media was full of bearish articles, people were getting fired all over the place, unemployment was rising, and the recession was deep. At such a moment, many simply capitulated, and sold everything they had because it got too painful.



Dollar Cost Averaging

Further, many think that they will simply buy more if a crash comes, but let me tell you what usually happens. First, the stock market declines, let’s say, 10% to 20%, and then stabilizes. The media is full of “buy the dip” headlines and you feel confident and start buying more only to realize the stock market falls another 20% and you simply buy more, but investors usually spend their buying power quickly as stocks are now down 30% or even 40% and it all seems a bargain.

Then there’s another blow with another decline and as the bottom can’t be seen (don’t get into the hindsight error, it’s easy to look at it like that), many fear buying and start to contemplate selling. All that you have carefully saved month-by-month and worked for over the past several years is disappearing in front of your eyes and it’s simply impossible to estimate what will happen.

I have a friend who sold everything in February 2009 after taking a 50% loss and didn’t invest anything back in the market until 2016 when he started putting some money back, but just pennies of what was there had been before. Unfortunately, this is a common story and leads me to emotions.

Emotions

Like it or not, we’re emotional creatures and are strongly under the influence of our emotions.

You might think you know how you will behave in the next market crash, but it’s unlikely as what you think now might change later and losses also impact us much more strongly than gains.

However, there are a few things we can do to try and exempt us from making emotional decisions that might not be the smartest thing to do as we all know the smartest thing to do to in a crash, and when stocks get cheap, is to buy and buy as much as you can.

Four steps to be prepared for a crash:

#1: Separate your lifestyle from your stock market portfolio.

This is hard. The whole economy is based on inflated asset prices that increase confidence and consumption, and now I’ll tell you to separate how you live from your paper gains and net worth. Well, that’s exactly what we should all do as it will keep us rational.

This includes having enough cash to pay for all expenses over a certain period of time, and to cover for surprises like job losses or other negative things that won’t wait for recessions to be over.

#2: Remain positive.

When losses hit us, it’s easy to turn negative and lose faith in capitalism and, therefore, rush for safety. But if that happens, think about the alternative. This is something that will make you feel much more comfortable with what you own.

The time to hedge yourself is not during a crash but before one.



#3: See how being hedged works for you.

Hedging is something that represents a cost and therefore, one should see how that fits their investment style and life cycle.

#4: Have a written investment policy.

A written investment policy that clearly tells you what to do in the worst case scenario, even one where stocks drop 90%, should be written now while you feel good and you haven’t been impacted by negative loss related emotions.

Think about why you are investing. Why are you owning certain investments and stocks? Think about how that can lead you to your goals. Write it down, put it into a safe place and re-read it when the next market crash comes.

If we can remain disciplined in the face of uncertainty and losses, we can call ourselves great investors.