There's no point in worrying about a stock market crash because you know at some point, it's going to happen. The stock market undergoes a correction of at least 10% about once every 1.84 years. Major crashes, like the COVID-19 crash of 2020, happen about once a decade.
Since you know it's coming, the only thing you can do is prepare. Here are five ways to be ready.
1. Get your emergency fund in shape
The best defense against a stock market crash is a healthy emergency fund. A cash buffer protects you from having to sell investments at a loss should you lose income or encounter an unexpected expense after the market has tanked.
Ideally, you want enough cash to cover six months' worth of expenses stashed away. A six-month emergency fund isn't built overnight, so saving six months' worth of expenses before the next stock market correction may not be realistic. But if you can find any extra money in your budget to put toward savings, even if it's only an additional $25 or $50 a week, you'll be better prepared.
2. Make sure your winners haven't gotten too big
You may think you have a diversified portfolio just because you own a bunch of stocks. But your investments may not be as diversified as you think, particularly if you've had some big wins recently. You may find that your winners now account for an outsize share of your portfolio, which can leave you vulnerable to a crash.
That doesn't mean you should shed your top stocks. But you might want to keep the same amount invested in your winners while using the earnings to diversify your portfolio. That's what Warren Buffett did when he cut Berkshire Hathaway‘s (NYSE: BRK.A) (NYSE: BRK.B) investment in Apple (NASDAQ: AAPL) modestly in 2020. He used the extra cash to diversify with four drugmaker stocks, plus Chevron (NYSE: CVX) and Verizon Communications (NYSE: VZ).
3. Avoid investing on margin
It's often tempting to increase your buying power by investing on margin. With margin, you basically borrow money from your broker to buy more stocks. If your broker has a 50% margin requirement, you could invest $1,000 of your own cash, plus $1,000 of your broker's cash in a stock.
If the stock rises 25%, you'd pocket 50%, not including the interest you pay on the margin loan. But if the stock drops 25%? Your loss is now 50%, not including margin interest.
Plus, as Motley Fool contributor Chuck Saletta described in March 2020, brokers have the right to change margin requirements at any time and can liquidate your investments immediately to bring you into compliance. Margining will only deepen the pain of a stock market crash and should be avoided by most investors.
4. Invest in dividend stocks
Investing in reliable dividend stocks can help lessen the blow when your shares are losing value in the short term. While dividend payments are never guaranteed, once a stock reaches Dividend Aristocrat or Dividend King status, it's a sign the company is committed to paying shareholders even during tough times.
Plus, companies that can afford to make regular dividend payments are typically well established with a steady history of profits. They don't have the potential for soaring gains you get with growth stocks, but their stability is appealing in a volatile market.
5. Set a schedule for when you'll buy more
Since a stock market crash creates panic, anything you can do now to remove the emotion from your decision-making is a good move. One option is to create a schedule for automatically investing after a crash. For example, you could plan to invest an additional $500 or $1,000 for every 5% drop in the S&P 500 index.
Of course, this is a strategy to consider only if your emergency fund is in shape and you've paid off high-interest debt. But if you're in a position to do, setting aside some extra cash to invest more when the market drops is a smart strategy. A crash is a lot less scary when you're prepared to use it as an opportunity.
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Robin Hartill, CFP has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple and Berkshire Hathaway (B shares). The Motley Fool recommends Verizon Communications and recommends the following options: long January 2023 $200.0 calls on Berkshire Hathaway (B shares), long March 2023 $120.0 calls on Apple, short January 2023 $200.0 puts on Berkshire Hathaway (B shares), short June 2021 $240.0 calls on Berkshire Hathaway (B shares), and short March 2023 $130.0 calls on Apple. The Motley Fool has a disclosure policy.