When I started investing heavily, the stock market was exciting to me. It was a game, and one heck of a challenge!
It was fun, but at the same time, it was also scary as hell.
I watched CNBC. I read the Wall Street Journal everyday. I had 3 monitors going and wanted more.
Then, I started, and it was hard. The emotions set in. The government was hitting the debt ceiling. I didn’t know what to do, and neither did anybody else in the world. I made money, then lost it all. I made thousands then I would lose $10,000 overnight. The market was in shambles, and so was I. I was spent. So, I stopped trading altogether.
And then I went to work. I learned the game. I became a student, and developed a plan.
Nowadays, my investing is the opposite of what it used to be. It is as exciting as watching paint dry. I watch the news literally zero minutes each month. I don’t worry about a stock market crash… because I’m prepared.
Now, I want to help you get prepared. I want to help you make your investing as exciting as watching paint dry so that you can 1) make more money, 2) stress less, and 3) go on living the life that you want to live.
Does that sound like a plan?
To get started, I asked a number of experts how to prepare for a stock market crash. Their advice will save you a lot of time and money, so read it closely and apply it today!
“First, we should define “crash.” To most, the term implies a decline of severe magnitude. The key missing element is the duration of the impairment, or how long does it take to recover?
A second consideration is whether the market was overvalued prior to the crash. There hasn’t been a stock market crash that began with stocks at historically reasonable valuations that persisted more than 5 years. The risk of a crash depends on valuation. The average PE ratio in 1929 was about 60 times earnings; 16 is considered average, and implies a 6.25% earnings yield. That’s reasonable.
Today, the PE for the S&P500 is 18.94 (as of 9/26/2014 according to the Wall Street Journal), and that’s a little above normal. It implies expectations that the economy and growth will continue to accelerate from the anemic post mortgage crisis recovery.
So how do you prepare, just in case? The conventional approach to hedging to stock market is to incorporate bonds into a portfolio. You own bonds for either of two reasons; either you need income, or you want to reduce the volatility of a portfolio. Currently the ability of bonds to generate income is diminished by Fed policy. While bonds may still provide some stability in the event of a crash, it is widely recognized that interest rates are likely to rise and that will reduce the value of outstanding bonds with fixed coupons. Choose your poison.
An alternative strategy is to focus on the likely duration of a downturn in the stock market, and plan for expected liquidity needs for that amount of time. A key benefit of financial planning is that it identifies liquidity needs. During this period of low interest rates, one can substitute a reserve strategy (often called the Bucket Approach) to provide for anticipated liquidity needs for as long as a crash/correction might be likely to persist. This frees the remainder of the portfolio for investment with a longer time horizon, and with focus of fundamental metrics like valuation and macroeconomic factors.
I share one other big thought. The conventional approach to investment management starts with a typical 40 question risk profile. The answers are scored and tallied to give a Risk Quotient. The profile indicates which model portfolio is used to manage assets, which puts the client’s emotional IQ in the forefront of investment strategy.
Emotional investing does not lead to the best investment results. I believe a goal of an advisor should be to help clients overcome emotional biases and invest with an eye toward a more cognitive approach, rather than pander to clients’ weakness. Plan for liquidity for 3 to 5 years. Notice the market recovered from the mortgage crisis in about 5 years. Depending on one’s circumstances, one might extend the reserves if market valuations (risk) rise; and even reduce reserves during a post-crash period when equities may be cheap. As Buffett said, be greedy when others are fearful, and fearful when others are greedy.” – Robert Dalton Higgins, Principal, Dalton Financial LLC
“Should you prepare for a stock market crash? This depends on a few things. First, what is your outlook?
Stocks have come a long way since the economic meltdown of 2008-2009. One could argue that US stocks are ‘fairly valued’ at this point.
Secondly, what is your current asset allocation, and when you will need the money you are investing? If your stock allocation is fairly low and you are a younger investor, you may not need to make much of a change. [Read more…]