The stock market is trading at a valuation only ever seen before near the height of the dot-com bubble. With stocks so expensive, it’s reasonable to expect lower average returns going forward, and perhaps even another crash in prices.
If the potential for a widespread price correction in the stock market is keeping you up at night, here are three things you can do to ease your worries.
1. Know your time horizon
The time horizon for your investments should play an important role in how you invest your money.
If you’re saving for retirement and it’s still 20 or 30 years away, you shouldn’t fret too much about the potential for a market crash. While it would be nice to be able to sell at the top and buy back in near the bottom, that’s tough to do. You’re better off holding your investments for the long run, and taking solace in the knowledge that the market historically rebounds higher over the long term.
If you expect to use most of your money toward a down payment on a house in a few years, you probably don’t want to invest as much in risky assets. While they have greater potential for returns over the long run, they also have greater potential to decline in value over shorter periods. Lower-volatility assets are likely more appropriate for that time horizon.
If you have a relatively short time horizon, but you’re investing like you’re not going to need the money for a few decades, then it makes sense that the potential for a market crash is keeping you up at night. A crash would have a major impact on your immediate financial plans. You need to adjust your asset allocation in order to quell your concerns.
2. Diversify your assets
If you’re not well diversified, a market crash could have a bigger impact on your portfolio than someone with better diversification.
In order to diversify properly, you need to invest in asset classes with minimal price correlation. That means a price change in one asset, like stocks, won’t show up in the price of another asset, like real estate.
Ideally, you want to offset riskier asset classes like stocks and cryptocurrency with assets that are negatively correlated in price. That way, when those parts of your portfolio are declining in price, other parts are rising in price. For example, U.S. Treasury bonds exhibit negative price correlation with U.S. stocks. Adding some short-term Treasury bills to your portfolio can temper its overall volatility.
If you’re afraid of a market crash, you may not be as diversified as you need to be in order to weather the storm.
3. Require a wider margin of safety for investments
Since timing the market is a fool’s errand (with a lowercase f), you should continue to seek out investment opportunities. However, with valuation concerns, you may require a wider margin of safety for new investments.
A margin of safety is the difference between a stock’s price and your estimate of its actual value. If you believe a stock is worth $100 and it’s trading at $80, you have a 20% margin of safety. Depending on your confidence in your valuation, that may be wide enough to invest in the stock even in an uncertain market environment. Maybe your temperament requires a wider margin; maybe you’re fine with a smaller margin.
If you’re worried about a stock market crash in the near future, you should put most of your new money toward securities in which you have high confidence and that have a wide margin of safety. A market correction could put a significant dent in some stocks, but if you correctly identify investments already trading below fair value, you should see them take less of a hit and bounce back faster.
The future of any individual stock or the stock market in general is always uncertain. Taking these steps can ensure your portfolio is ready to withstand a market crash if necessary.
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