The thought of a stock market crash happening can be very scary for an investor. And while no one can predict exactly when one will happen, you can rest assured that they do occur and they can't be avoided.
This very real potential investing threat could mean huge losses and a major hit to your hard-earned portfolio. But know that there are at least four ways to mitigate the situation and prepare for the eventuality and perhaps calm your fears and better manage your portfolio.
1. Review your risk tolerances and asset allocation model
When you invest, you should get rewarded for holding risky investments like stocks. That reward often comes in the form of earning a higher-than-average rate of return. But you should also understand that the riskier your holdings, the higher the extremes on that rate in both good years and bad years.
The table below, compiled by Vanguard, shows average annual returns between 1926 and 2000 among index funds using the asset allocation listed. It also shows the best one-year return rate for that model and the worst one-year return rate for the various asset allocation models. Note too that the number of years where a loss was reported increases as the allocation goes more toward 100% stocks.
19 of 95
30% stocks/70% bonds
18 of 95
50% stocks/50% bonds
20 of 95
70% stocks/30% bonds
23 of 95
25 of 95
Part of assessing your risk tolerances involves gauging your comfort level. You should examine how you feel about volatility but also make sure you can withstand all of the return rate scenarios that a particular asset class provides.
So if losing 43% of your wealth in a single year terrifies you, a portfolio made up of 100% stocks probably isn't a good fit. And a model with a slightly lower average rate of return but lower potential losses will probably make you more comfortable.
2. Rebalance your portfolio
As the stock market does well or badly, your asset allocation model could shift over time. This could result in you being either too aggressive or conservative compared to the model you chose. As an example, let's say we have $100,000 invested with 70% stocks and 30% bonds at the start of 2008. That year was not a good one for stocks (darn you, Great Recession!), and the $70,000 wound up as $44,100 by the end of the year. Bonds did better, gaining a little over 5% and turning $30,000 into $31,572. So at the start of 2009, an unchanged portfolio would be 58% stocks and 42% bonds.
In 2009, stocks began their recovery from the Great Recession and did well. If you left your 2008 asset allocations alone (58% stocks/42% bonds), you would have seen a 17.87% return in 2009. That's a decent return. But if you adjusted your portfolio allocation back to 70% stocks/30% bonds, your return in 2009 would have been more like 20.35%. Using our hypothetical numbers, not rebalancing costs the hypothetical investor $1,877 in potential returns just in 2009.
Because the stock market has done so well over the last 13 years, your portfolio may have experienced the opposite situation from our scenario above. Now instead of your allocations becoming less risky, they could've become riskier (i.e. more invested in stocks). A rebalancing may be overdue.
Rebalancing basically means selling a portion of your stocks and buying bonds when the stock market does well. And you will sell bonds and buy stocks when stocks have had an off-year. Most investment advisors suggest doing this once a year, but if there is a year with a lot of volatility, you could end up doing it more often. The goal is to get your allocations back in line with your risk tolerance.
3. Revisit stock market crashes of the past
Even though stock market crashes will happen, they don't happen often. Technically one happens when there is a loss of 10% or more in a stock market index in a short period of time. And since 1929, that has only happened five times.
But we don't know when the next one could happen. It could be tomorrow, next week, next month, or next year. And there is no exact way of telling how many years you'll have between crashes. For example, after 1929, the next crash didn't come until 1987. But a crash happened in 2007, roughly six years after the dot-com crash ended in 2000. The stock market had mostly positive growth following the 2007-2009 Great Recession until 2020's pandemic-induced crash.
What you can take from this information is that even though you'll probably endure at least one crash in your lifetime, you probably won't experience many. And if history repeats itself, you will probably get many more years of positive growth than negative.
4. Get a long-term investing perspective
Even knowing that crashes are relatively rare, you still need to answer some questions about how you are investing. What is the money for? Are you saving for a goal like your retirement that's 20 years or more out? And if so, how much of an impact will a stock market crash now have on you meeting your goal?
Say, for instance, you lose 20% of your portfolio because of a crash but you don't need the money for 25 years. You'll have plenty of time to recover those lost funds. That would suggest you can be more aggressive with your asset allocation. But what if you'll need your money sooner? That's when you should rethink an aggressive asset allocation model. If you don't have enough time, you risk having to sell your stocks before they've recovered from a crash. Money that is needed over the next year or two should be kept out of the stock market completely.
Short-term losses are a part of the investing process and often aren't worth avoiding. Instead of trying to time the market and stave them off completely, keeping these important lessons in mind can help you get through a stock market crash much easier.
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