How to Prepare for the Next Stock Market Crash

My first big stock market crash was the Great Recession in 2007-2009. I was working at a major hospital in Massachusetts when the financial system collapsed due to risky lending practices and derivative trading in the banking industry. I was 7 years into my career so I didn’t have too much money invested at the time. I remember my 401k dropped by 50% (yeah I made the mistake of looking!). I continued to make weekly contributions to my 401k through payroll deduction during the crisis and thankfully I worked in healthcare so my job was “safe”. Conveniently, I rebalanced my portfolio after the drop to move away from bonds and into growth stocks to take advantage of the lower prices. 

The first known market crash in history is the Tulip Mania speculative bubble of 1637. Tulips were first introduced in Europe in 1554 from the Ottoman Empire. The flowers were unlike anything seen prior to their arrival so they rapidly became a luxury item in the Netherlands. Prices steadily rose as growers paid higher prices for bulbs to meet the demands. Speculators entered the market and drove the prices up ten times the annual income of a Dutch artisan. Tulip bulb contracts were changing hands up to ten times per day with increasing prices between each sale. The mania swept the Netherlands with some people trading up to 12 acres of land for a single tulip bulb. Eventually the mania came to crashing halt and tulip bulb trading was stopped. Many people were left holding worthless contracts for tulips and no supply.

In modern times, we deal with various crashes (rapid and slow rolling) in the stock market all the time. A pullback, correction, bear market, and recession are all terms used to describe a period of decline. 

Pullback – A stock market drop of 5-10% in a very short time period.  Pullbacks can happen multiple times a year so we can expect rough patches throughout the year.

Correction – A stock market drop of 10-20% that can last weeks to several months. On average, corrections occur every two years.

Bear Market – A stock market drop of more than 20% over at time period greater than two months. Between 1900 and 2018, the Dow Jones experienced 33 bear markets. 

Recession – A period of economic decline that is reflected as two consecutive quarters of decline in GDP. 

Market crashes happen. We should expect them to happen. Having a plan for before the crash, during the crash, and after a crash can set you up for nice financial gains during turbulent times. 

Source: New York Times

Before the Crash  

There are several things that investors can do to prepare for a crash.   

Emergency Fund – Experts recommend that people should have 3-6 months of expenses saved up in an emergency fund at all times. These funds are typically tucked away in a high-yield savings account or parked in a safe bond fund. Emergency funds should never be touched unless there is an emergency!  

Pay Down High Interest Debt – Long bear markets and recessions can often impact employment across several industries, cause banks to stop lending, and create uncertainty. Paying down high-interest debt (anything over 5%) is a must to prepare for a crash. The peace of mind that comes with not having monthly payments during a crash is worth the effort and it can free up cash flow to invest during the crash!

Diversify Your Portfolio – Having a balanced investment portfolio can minimize risk and a ease the pain with the crash. Many new investors have target date funds to accomplish diversification and more seasoned investors will construct a fund that is more tailored to risk tolerance and investment goals. (I will share more about the three-fund portfolio in a future post).

During the Crash

The crash itself can feel scary. News articles fill social media with the doom and gloom. Friends and family talk about the “Dow Jones” crashing in everyday conversation. It is important to remember that you never lose money unless you sell. You still own the same number of shares! There are some things that can be done during the crash to improve your odds of making it out on the other side on better financial footing. 

Remain Calm and Don’t Panic Sell – The best way to LOSE money is to buy high and sell low. During a crash it is important to trust the plan you set up BEFORE the crash and remain calm. Our gut tells us to sell. Our gut tells us that the stock market will go to zero. Don’t listen to your gut! History tells us that the market will come back and higher than before the crash. Don’t sell. 

Dollar Cost Averaging (DCA) – This is an investment strategy where the investor makes regular, periodic purchases of a stock/fund in an effort to reduce volatility of a single purchase. There is no way to know when the market has hit the bottom of the crash so making regular purchases will average out to be lower than price prior to the crash. This is easy to accomplish with weekly/bi-weekly payroll deductions into a 401k.

Everything is On Sale – If you have a good emergency fund and no debt then making additional (beyond DCA) might be a good opportunity. Companies that looked good before the crash now have stocks that sells at a discount. Picking up stocks and funds at regular intervals at the pull-back (5-10%), correction (10-20%) and bear market (greater than 20%) are nice easy purchase points.

Stop Checking (If you need) – Obsessing over the market crash can lead to very poor decisions. If you are unable to remain calm then it is probably best to stop looking at your portfolio all together. Out of sight out of mind is sometimes the best approach for many investors.