How to Prepare for a Stock Market Crash

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.

I was going to be a professional trader – the next Gordon Gecko or Jordan Belfort.

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?

Good. 🙂

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!

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“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

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“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. 

Pre-retirees and retirees, however, can plan for a stock market crash by having a minimum of three years of living expenses in a money market fund. This way, they won’t have to sell any positions if the market were to crash. At the end of a year they can sell enough to replenish their money market account and have three years of living expenses.

Other investors can simply raise cash by selling equities. This should only be done on the margin and not make wholesale changes. For example, if someone was currently 60% in stocks, they might want to trim it to 50% in stocks. Anything much more that this would be an attempt to time the market and very few investors have ever done this successfully.

Investors could also consider gold and other commodities as a hedge, but this has not played out well recently due to the slowdown in China.” – Thomas F. Scanlon, Financial Advisor, Raymond James Financial Services, Inc.

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“If you are invested in the stock market at all, a crash is going to typically hurt you in one way or another. However, there are ways to mitigate potential losses.

You should never be heavily invested only in stocks. One common rule of thumb is to take your age and subtract it from 120 and use that number as your percentage held in stocks. The rest should be in bonds. Another way to protect yourself is to hold a percentage of your investments in international stocks, which may have a smaller chance of being affected by a crash (assuming it isn’t a worldwide crisis that causes it).

Putting a portion of your investments into precious metals such as gold bullion or silver coins could also add a layer of protection.

As a more external tip, pay down your debts and other financial obligations as much as possible. That will make surviving a potential crash a lot easier. If you truly believe a crash is coming, you might want to put an even higher portion of your investments into bonds, and not stocks. And yes, I do think that it’s important to prepare for a crash, even though it’s basically impossible to predict when one may be coming.” – David Bakke, MoneyCrashers.com

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“I have lots of thoughts on this one:

1) Have cash ready to put in the market when stocks are on sale. Those who had money to invest in 2009 took advantage of the low prices resulting from the 2008 crash.

2) If you are a covered call writer, start writing calls that are slightly in-the-money and have shorter expiration periods.

3) If you don’t use options to hedge, place stop losses on your stocks and exchange-traded funds which have unrealized gains.” – Laurie Itkin, The Options Lady

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“No one has ever successfully predicted market crashes over a sustained period of time. With the bull market in it’s 5th year, the call of a major crash is becoming more prevalent. So what is the average investor to do?

For most investors, the goal of investing is to accumulate wealth and sustain that wealth through retirement so that you can retire in your 60’s and have money to live well on for the rest of your life. If you haven’t guessed it already, this means investing/retirement is not a fixed point in time, it is a journey and usually one that lasts 30 years or more.

There is no denying that as you get older, you lose the time aspect in the “time value of money” equation that allows compounding returns to significantly increase your investments. Therefore you should think carefully about your investment strategy and have an asset allocation in your total portfolio that fits your time horizon (estimated future date when you are going to use the money) and risk tolerance (your ability to ride out the ups and downs of the market).

If you want to be conservative, fine… just look out for rising interest rates and stay away from bond funds. Try high dividend paying blue chip stocks (like AT&T) or ladder non-callable individual bonds with attractive yields.

If you want to stay in the market, fine… find good mutual funds or stocks that have growing prospects and possibly pay dividends. Invest in things you understand.

Most of all, STICK WITH IT!

What killed average investors in 2008 wasn’t the down turn (the market is up well over 100% since then) it was that people got scared, panicked, and cashed out at the bottom. The goal is to sell high and buy low, not the other way around.

When the market turns down, that is just like a major sale at your favorite retailer. Find the items (stocks) you like, and buy them regardless of how much they are discounted! Market timing – try to get in and out at just the right time – leads to high transaction costs, emotional investing, and ultimately major losses.

Seek the guidance of a professional, develop a plan, and stick with it. That is how you prepare for a market crash.” – Joshua Duvall, Certified Financial Planner, Capital Financial Services, LLC

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“The common investor needs to decide how much risk he/she can handle without having major regret after a significant market correction. If there is some life event that makes this investor suddenly more risk averse, then it’s rational they take some funds out of the market.

But if there is no major change in the investor’s personal situation, they should stay the course. It is folly for investors with long-term goals to try to time the market. Identify the risk level you are comfortable with, invest in an asset mix that matches that level and keep it there.
The worst thing an individual investor can do is to follow the market too closely. The flow of information, analysis and opinion is overwhelming. Even professionals are prone to overreact. With few exceptions, individual investors should focus on their goals, form an appropriate asset mix and revisit their plan at least annually.” – Paul Bolster, Professor of Finance, Northeastern University

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“If an investor needs to prepare their portfolio for a crash, they’re not appropriately invested in the first place.

An investor should understand the risk tolerance and variability of their portfolio in all conditions. As such, a crash/correction would just be a normal phase of an investors portfolio life. We believe portfolio allocation and locations should be reviewed and rebalanced periodically, but should never be traded on a reactivate basis due to any circumstance or event, whether past or pending.” – Leonard P. Raskin, Certified Financial Planner, Park Avenue Securities, LLC

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“Really nothing. If you set a portfolio up that balances risk and returns based on your individual needs and risk tolerance you should be fine. Unfortunately most people do not take the time to understand the right allocation needed.

However, for those that have set up the most prudent portfolio, you should never change your allocation based on market events – only on your own personal life events.
As Peter Lynch said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Charles Massimo, President, CJM Wealth Management

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The key to corrections and even crashes is not to panic. Panic is what costs you money. Crashes very seldom strike in a moment from a blue sky. The moment tends to start with a period of bearishness. So at this point the thing to do is look at all your investments and make a simple judgement call. Sell or hold. Lightening up before a correction is good practice if some winners’ profits loom too large. Going to cash in a measured way is good practice.

The key to buying a crash or correction is to take it slow. The slump will not be over overnight. Let the slump settle, wait till the media is telling you how the dream is over. Then roll back in gently.

We all hate the prospect of a slump or a crash, but in fact they are little gifts to long-term investors. While the crazy speculators get toasted, savvy people get to buy stocks at knock down prices. – Clem Chambers, CEO of global stocks and shares ADVFN

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In summary, here is what you should know:

• “Crash” is a strong term. It indicates a severe decline, and these rarely (if ever) start without the valuation of stocks to be extremely high.
  • The current valuation is nearly 19, while the historical average is ~16
• If you’re in need (near retirement), you want to have 3 years of savings in a liquid account.
• If you have a long time before retirement, you may not have to make any changes or preparations for a stock market crash.
• Asset allocation is an important diversification test to help ensure your level of risk exposure matches your goals.
• Rebalance as necessary to be prepared.
• Some good ways to reduce your risk to a certain market crash are by buying commodities (i.e. gold, silver) and international stocks.
• Pay down debts and take care of other obligations. This makes surviving a crash much easier to do.
• Place stops on your investments to protect you in case it is a stock market crash.
• Have cash on hand and ready in case stocks do “go on sale.”
• Options can be a great way to hedge your portfolio and make money in any market environment, although I do strongly suggest you learn a lot about them before you get started because you can lose money quickly. (I used to trade them before I knew what I was doing and I lost a lot of money. More training to come on stock options in the near future!)
• Market conditions should not change your plan (because then you’re acting on emotion), but life events definitely can.
• If investing is a long-term game for you (which it should be for most), then market crashes and corrections are “little gifts” that should not only be expected, but should be appreciated in the bigger scheme of things.

So, that is how to prepare for a stock market crash. The key is to create a plan, and more importantly, stick to the plan! Not doing either one of these things will end up in a much lower level of wealth and also the most costly thing you can have: regret.

So, take the experts’ advice seriously. Create a plan that fits your needs and goals, and put that plan into action. Sign up here to get updates on the next True Wealth Master Class training from YoPro Wealth – including Investing 101 and much, much more!

Take control. Make money. Live Wealthy.

Other links to check out:

• Stock Market Investment Tips
• The Stock Market Can Crash Any Time
• 5 Things to Do in a Market Correction
• The End of QE Era is Upon Us

The Experts:

• Laurie Itkin, Financial Advisor and Author, “Every Woman Should Know Her Options“
• Thomas F. Scanlon, CPA, CFP, Financial Advisor, Raymond James Financial Services, Inc.
• Clem Chambers, CEO, global stocks and shares website ADVFN
• Robert Dalton Higgins, MBA, CMA, CLU, ChFC, CFP(r), Principal, Dalton Financial LLC
• David Bakke, Finance Expert at Money Crashers.
• Joshua Duvall, Financial Planner, Capital Financial Services, LLC.
• Leonard P. Raskin, MSFS, CFP, ChFC, CLU, CAP, CASL, AEP, Financial Planner, Raskin Global, Park Avenue Securities, LLC
• Charles Massimo, President, CJM Wealth Management
• Paul Bolster, Professor of Finance, D’Amore McKim School of Business, Northeastern University