If all you had to assess the state of the economy was the stock market, it seems that everything is fine. After falling 34% in just over a month in February and March, SPDR S&P 500 ETF Trust (NYSEMKT: SPY) has jumped 37% and has fallen only about 5% since the beginning of the year.
Only this – such a break between stocks and what is happening in the real world – many investors are convinced that another market catastrophe is inevitable. But isn’t it? Absolutely. There is no doubt that we will see a stock market crash again. Let’s talk about how you can prepare.
The most important thing you need to know
We do not know when the next market catastrophe will happen. As inevitable as it may seem, we just don’t know. The last 10 weeks has been an excellent example of how to predict market failures is almost impossible.
Think of it this way: On March 23, 3.3 million people had re-applied for unemployment as part of a blockade effort. At that time, 31,000 Americans were diagnosed with COVID-19 and about 400 died. On this date S&P 500 hits the bottom, down about 34% of the February 20 high.
Fast forward to today and there are almost 1.8 million confirmed cases of COVID-19, more than 104,000 Americans have died and millions more are out of work as unemployment has jumped to almost 15%. And yet the market is 37% higher than 10 weeks ago
This is a reminder that in the short term, calling at the top – or bottom – with stocks is pure luck.
The biggest mistake to avoid
Which leads us to the mistake we need to avoid: selling stocks to try and spend your time in the next market crash. Today, there are millions of people on the sidelines selling somewhere in late March or early April, convinced that things will get worse before they get better. Instead, they missed the mass – inexplicably – rally on the stock exchanges from the end of March.
The stock number is to remember no tricksStocks are property in the business. Many are stunned by the effects of COVID-19; some will not survive. But the best business will go through this and return to growth as the world goes through this crisis. The hard part is overcoming the downturns so you can benefit from getting back to normal.
The stocks are amazing long-term sources of wealth creation This is true even if you are buying into something that seems like the worst possible moment. For example, if you invested in an S&P 500 index fund such as the SPDR S&P 500 ETF Trust in early October 2007, the next few years would feel awful.
But even for people who bought at the peak of the previous collapse, stocks have brought great profits. Even from the peak before the Great Recession to the bottom of this year’s coronavirus catastrophe, stocks outperform bonds represented by Vanguard Total Bond Market ETF 09.30 NASDAQ: BND:
The stock has a long history of outperforming the “safety” of bonds for long periods of time, even from the “worst” time to buy before the collapse, to the “worst” time to sell on the newest market bottom.
The first action you take with your long-term investment is no action. The odds are much higher that you will win if you leave your shares alone and let the power of owning large companies pay off for many years.
Selling the idea of ”going out” before the next crash certainly turned out to be a mistake for many investors this year. The story becomes clear: The weather in the market works; synchronization the market does not.
Actions you can take to be ready for the next disaster
So what can you do to be ready for the next disaster? Make sure you have cash ready for three important – but separate things:
- Unexpected costs
- Estimated costs
- Investing for profit from the next crash
Create an emergency fund
Recessions, job losses, diseases, natural disasters and other things can happen unexpectedly. In addition to having the right types and amounts of insurance, you should strive to save cash that can cover six or more months of basic living expenses.
Your need for this money may arise with or without a market crash; having an emergency fund means that you will not be forced to sell shares to cover unexpected expenses just when you need to buy.
Protect the assets you will need soon
While your emergency savings are being prepared for unexpected short-term needs, you also need to prepare your portfolio for these expected a need soon arises
For this reason, it’s a smart idea to start shifting some of your investment from stocks to high-quality bonds and cash a few years before you retire, sending a child to college or whatever you’re investing. The goal is to spend several years in these low-volatility assets before you need them.
Of course, bonds and cash do not yield anything close to what you can get from dividend stocks, and you will miss the upward prospects of stocks. But at this point in your financial journey, your goal should be to limit bad side of unexpected losses for money that you will rely on for the next few years.
Set aside money to invest in the next disaster
We have already addressed the risk of moving too much of your portfolio in cash. Can you imagine that at the end of March you moved heavily in cash (maybe you could) just to watch the shares float backwards? If it’s you, it probably will be really at this point it is difficult to get back into stocks. But history has shown that it is a big mistake to play the short-term guessing game just to miss the long-term winning buy-and-hold strategy.
So with that said, a useful strategy is to keep a small portion of your portfolio – say, about 5% – that would usually be invested in stocks and keep it in cash to invest when the market falls fast.
Here is the plan I use with the money in my portfolio:
- When stocks fall 10% from a recent peak, I invest half the money in my wallet.
- When stocks fall by 20% from a recent peak, I invest half of the rest of the money.
- When stocks fall 30%, I invest the rest of the money.
Why these levels? In short, as we see 10% falling approximately once a year or two, and 20% falling about once every five to seven years; a 30% drop has occurred only six times in the last 70 years. Retaining money for bigger drops is a losing move, as the market has always recovered much more than it lost before falling 30% or more again. Of course, we may see another 30% decline next year or less; the story goes that you are not likely to bet your farm.
Winning strategy for today and tomorrow
The plan above can help you avoid the following actions to destroy wealth:
- Making the unforeseen mistake of selling stocks just because the market collapses, just to miss the refund while sitting in cash.
- Engagement of forced mistake in having to sell in a crash because you need money now.
- Saving too much money on the sidelines for the next crash and hurting your long-term returns.
If you are sitting on a lot of money, relying on another major disaster that happened soon, look at history as a guide. Stocks could fall again soon, or it could be years – and many gains – before the next big drop. On the other side of the coin, if you are too exposed to stocks with assets that you will have to pay off in the next few years to pay for some financial need, it may be time to sell some of your shares and get your assets distributed in order.
Either way, if you don’t have a solid plan to cover your short-term and long-term goals and needs, it’s time to set one and start working on it. You will be in much better shape when the next market crash happens, whether this year or many years from now.