You may not like what I'm about to say, but it's the truth: A stock market crash is inevitable.
Of course, we don't know precisely when the next crash will occur, how long it'll last, or how steep the decline will be. But we do know that, based on history, double-digit declines in the benchmark S&P 500 (SNPINDEX: ^GSPC) are more common than most investors probably realize.
History is clear: A crash is coming
If we were simply to take a walk down history lane and let the averages guide us, the prospect of a double-digit correction or crash over the next 12 to 18 months is very high. For example, every single bear market dating back to 1960 (not counting the coronavirus crash from 2020) has had at least one double-digit percentage retracement within three years of hitting a bear-market bottom. More than half of those bear markets actually had two double-digit declines within three years. We're now nearly 14 months removed from our bear-market bottom and have yet to face a double-digit drop in the S&P 500.
Furthermore, the S&P 500's Shiller price-to-earnings (P/E) ratio is worrisome. The Shiller P/E ratio, which takes into account average inflation-adjusted earnings over the previous 10 years, closed at 37.32 this past week. The 150-year average Shiller P/E for the S&P 500 is only 16.82.
But the real concern is that each of the previous four times the S&P 500's Shiller P/E has crossed above and sustained the 30 mark during a continuous bull market, it's subsequently declined by a minimum of 20%.
Also, there have been 38 double-digit percentage drops in the S&P 500 over the past 71 years, according to market analytics company Yardeni Research. That's a sizable drop, on average, every 1.87 years.
History is pretty clear: A crash or sizable correction is inevitable.
Your 10-point checklist for the next stock market crash
However, this doesn't have to be bad news for long-term investors. As long as you're prepared mentally and financially for a crash, it can actually be an incredible moneymaking opportunity. Below is a 10-point checklist to get you prepared for the next stock market crash.
1. Breathe, this happens all the time
The first thing to do when panic-selling crops up is to breathe deeply and realize that this is a normal part of the long-term investing process. You might even call it the price of admission to the greatest wealth creator on the planet.
As noted, a double-digit decline has occurred every 1.87 years since the beginning of 1950. But what you might not realize is that every single one of these 38 crashes and corrections in the S&P 500 has been erased by a bull-market rally. In many instances, it's only taken weeks to a few months to put sizable drops in the rearview mirror for good.
2. Understand your risk tolerance before a crash occurs
Well before the next crash or sizable correction strikes, it would be a wise idea to understand your investment risk tolerance. For instance, if the sight of your high-growth stocks losing 50% is going to cause you to lose sleep, you probably shouldn't be invested in growth stocks. I use this as an example because a lot of the top-performing growth stocks over the past year did, indeed, lose close to half their value during the coronavirus crash.
Keep in mind, though, that investing conservatively doesn't have to mean giving up significant wealth creation. Hypothetically speaking, if you had purchased an S&P 500 tracking index in 1980, you would have endured the worst single-day crash in 1987, the dot-com bubble, the Great Recession, and the coronavirus crash. Your reward? An 11% average annual total return (including dividends) even with these declines.
3. Take the time to regularly reassess your holdings
Though you don't have to wait for a crash to crop up, panic selling in the broader market is always a good time to step back and reassess your holdings. By this I mean evaluate whether or not your initial investment theses still hold water. In many instances, the reasons you bought into a stock in the first place are unlikely to be altered by a stock market crash or correction.
In the rare event that your investment thesis is altered or broken, it might be worth selling your stake or reducing your position.
4. Ignore emotion-driven white noise
We're normally not going to know what causes a stock market crash until it's well underway. But the biggest driver of crashes isn't necessarily news. Rather, it's the emotion-driven panic of short-term traders.
We can't control how other investors are going to behave when stock market crashes pop up. What we can do is lean on history and our investment research, which tells us that crashes and corrections are often very short-lived. Ignoring the raw emotion that rises to the forefront in the very short term during stock market crashes is important to building wealth over the long run.
5. Have cash at the ready to take advantage of discounts
This might go without saying, but it's always a great idea to have some dry powder at the ready to go shopping when the stock market crashes. Since every single crash or correction is eventually wiped out by a bull-market rally, it means every major dip in history has proved to be a buying opportunity. As long as you're focused on the long term, crashes are akin to once-a-year sales at your favorite retailer.
6. Avoid margin like the plague
Aside from not allowing emotions to get the better of you, the other thing you absolutely don't want to do during a crash or steep correction is leverage your buys with margin.
Buying on margin puts you at risk of losing more than your initial investment, and you'll be forced to pay interest on the money you've borrowed. Moreover, using leverage marks an attempt to time the market, which can't be done with any accuracy over the long run. Margin can be tempting when the long-term trend of the market is “up,” but its use during periods of heightened volatility is way too risky.
7. Nibble frequently, because timing the bottom is impossible
Arguably the most common question I get asked when the S&P 500 is crashing or in correction is, “When should I buy?” The answer is simple — often.
In recent years, most brokerages have gotten rid of their trading commissions, and many even allow investors to buy fractional shares. This means you can drop $5,000 into your favorite group of stocks, or put $5 into a fractional share of Amazon right now. Since we're never going to know how steep the decline will be or how long a crash/correction will last ahead of time, it's best to nibble frequently when they occur.
8. Add to your winners
Motley Fool co-founder David Gardner has long believed that it's much smarter to add to your winners than to double-down on your losing investments. Winning stocks are winners for a reason. They're often innovative, may offer competitive advantages, and have superior long-term growth prospects relative to the broader market or their industry.
The point is this: When panic selling sets in, leaning on your outperformers should give your portfolio a better chance to thrive once a bull market takes shape.
9. Buy dividend stocks (they're proven winners)
In terms of categories to buy during a crash, don't overlook dividend stocks. Publicly traded companies that pay a dividend are almost always profitable and have time-tested operating models.
More importantly, dividend stocks have run circles around non-dividend payers over the long run. A J.P. Morgan Asset Management report released in 2013 compared the annualized average gain of companies that initiated and grew their payout between 1972 and 2012 to companies that didn't pay a dividend. The result? Dividend stocks averaged a 9.5% annual return over 40 years, compared to a meager 1.6% for the non-dividend stocks over the same span.
10. Don't forget about value stocks
Lastly, value stocks would be a smart addition to your portfolio when the selling accelerates during a crash or steep correction. Not only are the vast majority of value stocks profitable, but value tends to outperform growth substantially during the early stages of an economic recovery. Hint, hint… that's where we are right now.
10 stocks we like better than Walmart
When investing geniuses David and Tom Gardner have an investing tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*
David and Tom just revealed what they believe are the ten best stocks for investors to buy right now… and Walmart wasn't one of them! That's right — they think these 10 stocks are even better buys.
Stock Advisor returns as of 2/1/20
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Sean Williams owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends the following options: long January 2022 $1,920 calls on Amazon and short January 2022 $1,940 calls on Amazon. The Motley Fool has a disclosure policy.