How to Prepare Yourself for a Stock Market Crash

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Stocks have historically proven to always go up over the very long term and have provided many investors the opportunity to build massive wealth. However, stock markets don’t always go up and recently, news and media are constantly pumping out speculations on how the market might look like in the following years, while many investors are almost certain that the stock market is going to dip into a long bear market within the next few years. If you are going to invest over your lifetime, it is not unlikely that some stock market crashes are going to happen along the way. That’s just the nature of the stock market but every single time you can prepare yourself for the next upcoming market crash.

One of the most important rules when it comes to investing is that you can’t time the market. No one can predict when a market downturn is going to occur. However, it is safe to say that the market is going to crash at some stage because that’s how markets behave. They operate within economic cycles.

Instead of spending your time and focus on vague predictions from the media and ‘experts’ about the future outcome for the market’s behavior (whether they’re bullish or bearish), you should instead structure and position your investment portfolio accordingly to the current situation. This article is going to walk you through some fundamental methods, which you apply to be prepared for the next stock market crash.

There are several approaches that you can take to minimize your loss as soon as a crash occurs:


Keep Your Portfolio Diversified

Maintaining a diversified portfolio reduces your risk to suffer a severe loss significantly. You should never rely your entire money on one single asset, even if it may look like the best investment ever since the risk for you to lose a substantial proportion of your portfolio is simply too high. If that single investment goes down in value, your whole investment portfolio goes down.

By having a diversified portfolio, you are holding assets, which don’t correlate with each other. This means for instance, that whenever stocks are falling due to an economic downturn, assets such as bonds or commodities are likely to go up, effectively offsetting the loss from your stocks.

Hence, if you hold a simply diversified portfolio with 40% bonds and 60% stocks and the stock market tanks, you are effectively suffering a smaller loss than having 100% invested in the S&P 500 because of the increasing value from your bonds.

Even though one should be expecting a less return with a balanced portfolio than being 100% in one single asset class like stocks, it is the less risky way to go. Proper investing is not only about the return but also about the risk factor that comes with each investment made.

Here’s an example of how a diversified porfolio may look like:

The pie chart above represents a very straightforward and simplified asset allocation. The purpose of it is to show you how diversification may look like.

Please note that you assess for yourself, which kind of asset mix suits your personal investment needs. Your portfolio should always resonate with individual factors like your investment time horizon, financial needs, and risk tolerance.


Rebalance Your Portfolio

Leaving your portfolio and letting it do the work for the rest of your time horizon isn’t a terrible idea but definitely not the optimal one. Because the weight of each asset is continually going to change over time. And thus the risk allocation within your portfolio won’t match with your initial goal and strategy.

For example, after a stock market crash, the weight of your stocks is going to decrease, while bonds are likely to increase. The proportion of your assets is now different than before and it would be time to rebalance your portfolio.

You’ve just read that the market can’t be timed. However, by rebalancing your diversified portfolio, you generally buy asset classes at their right times automatically.

When stocks go up, they will become a bigger part of your portfolio. In order to maintain the initial proportion, you sell a part of your stocks and buy bonds to reach your initial allocation. On the other side, when stocks go down, you sell some of your other asset classes and buy into stocks to get to your normally-balanced portfolio. This method is easy to follow and essentially leads you to sell overpriced assets and invest in underpriced assets naturally.


Use Precious Metals as a Hedge

Having a small part of your portfolio invested in precious metals like gold can be very useful, especially during a stock market collapse.

Many investors view gold as a safe haven, where they feel protected against any kind of catastrophes as soon as it happens. When something uncertain like a market downturn starts to occur, they get scared and many investors try to allocate their money into an asset that they consider safe. Gold has many characteristics that make it an attractive commodity and that’s why gold tends to spike up shortly after a stock market crash.

Therefore, it isn’t a bad idea to allocate a fraction of your portfolio into gold as a hedge. It can potentially reduce your effective loss through its gain of value. But again, rebalancing the increasing proportion within your portfolio is vital whenever its weight increases, because stocks tend to recover fast after that short period of time within the crash, as investors start to recognize and repurchase undervalued companies.


Have the Right Mentality

The stock market crash in 2008 took 18 months, and stocks fell more than 50%. It is easy to say that investors just should have been patient and bought the dip while waiting for stocks to recover. Many investors are already aware of the fact that selling as soon as the market dips, is wrong.

However, people underestimate the control of their emotions when a severe economic crash occurs like in 2008.

Imagine waking up every morning and seeing your portfolio constantly decreasing. You may be optimistic for the first few months, but can you maintain that state of mind and stay positive for one and a half years?

Lots of investors lost their patience and capitulated within the last months of the market downturn, right before it rebounded. They made their temporary loss into a permanent one.

That’s why it is essential to be prepared with the right mentality and awareness of what can really happen in the next crash and how your mind is going to react to it. You don’t want to make the same mistake as many investors did in 2008.

The next stock market crash might take much longer or it might be even more painful and significant. Ask yourself if your emotions could truly handle that and try to separate your financial portfolio from your lifestyle as much as possible.

Conclusion

  • Diversification plays an essential role as a protection against bad times.
  • Rebalancing makes sure that you smooth out your risk allocation, while also automatically providing you with proper investment allocations.
  • Having a hedge like gold can potentially offset a severe loss within your portfolio.
  • Don’t underestimate your emotions and prepare your mentality for the worst scenario.

     

Technically it is not hard to be prepared, but in practice, it is extremely difficult to have and maintain the right mindset along with a good amount of patience to successfully withstand a bear market.

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Disclaimer

The information on this website is not intended as investment advice. Do not consider the information as individualized financial advice or advocation to buy and sell any finanical securities. 

Investing comes with inherit risks. Therefore, you should always consider seeking investment advice from a professional who is aware of your individual financial situation. You are responsible for your own investment research and decisions.

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