When the stock market hits a rough patch after a long Bull Market, it might cause you to think “Should I get out of the stock market?” and “What should I do with my money?” The answer is it depends. Every year, you should be evaluating your needs and adjust your investment strategy to fit those needs. Personally, I still have two more decades to go, so I am holding steady and continuing to invest for the long-term.
Putting Things in Perspective
If you are reading this because the stock market just crashed big time and you’re thinking about selling to get out of the market…DON’T!
The best thing you can do right now is to do NOTHING. Wait and evaluate.
Here is the S&P 500 Historical Return with the last three MAJOR STOCK MARKET CRASHES highlighted.
As you can see, the Stock Market will go up over the long run.
How to Build an All-Weather Portfolio
I believe these four steps will help you build a profitable long-term investment portfolio:
1. Risk Tolerance Level
Have you taken one of those risk tolerance tests? Did you get a rating like “aggressive investor” or “very aggressive investor”? Maybe it is time to take another test to see if you still feel the same way you did back when you first took one. Your life situation and financial priorities could have changed — e.g., you got married, you bought a house, you gave birth to a child, etc.
Understanding your current risk tolerance level and where you stand is a good place to start.
2. Investment Time Horizon
Even if you are still optimistic and your risk tolerance level still says you are an “aggressive investor,” you now have a shorter investment time horizon. As you get closer to your retirement age, you should consider shifting more of your investment portfolio away from stocks toward less volatile investments that focus more on generating income.
3. Asset Allocation
Does your asset allocation align with your risk tolerance level and investment time horizon? If you have been religious about rebalancing your portfolio, but haven’t changed your allocation for a while, this may be an excellent time to take a good look at it.
Here is an Asset Allocation Calculators from CNNMoney.com to help you with your allocation. Does your current investment mix in line with the ideal asset allocation? As you can see, two investors with the same Risk Tolerance, but different Investment Time Horizon has very different recommended allocation.
Does your investment consist mainly of individual stocks? If it does, I recommend that you read Wise Investing Made Simple: Larry Swedroe’s Tales to Enrich Your Future by Larry Swedroe. Larry believes that the best investment strategy is to be a disciplined, long-term, buy-and-hold investor that utilizes a globally diversified portfolio of low-cost, no-load, and passively managed funds and ETFs. I also believe in this strategy.
In short, invest in funds and ETFs instead of individual stocks
Now let’s take it a step beyond the typical diversification when we think about investment — i.e., stock vs. bond, large-cap vs. small-cap, domestic vs. international, value vs. growth, etc. Do you have other types of investments that are generating alternative income, or appreciating in value?
- Real estate
- Precious metal and gems
- Debt instruments
Do you believe your investment portfolio is diversified?
What to Do Before a Stock Market Crash
If you follow the steps above and you can hold your investments through a crash, you could simply wait it out and let the market recover.
However, if you’re still nervous, you could make some additional adjustments to your portfolio to help ease the pain when the market eventually crashes.
1. Tactical Asset Allocation (TAA)
If you expect the Stock Market to perform poorly, you could temporarily shift your investment away from Stocks.
Let’s say your desired asset allocation is 75% Stocks, 23% Bonds, and 2% Cash; you could shift your allocation toward Bonds and Cash. For instance, your temporary asset allocation could be 55% Stocks, 38% Bonds, and 7% Cash.
Your portfolio is likely to have a lower rate of return if the market continues to climb. However, you would be in a much better position to take advantage of the market recovery with your larger bonds and cash positions.
2. Invest in Dividend-Paying Stocks
There is a consensus that dividend-paying stocks tend to do better in Bear Markets. The theory goes as follow:
Dividend-paying companies tend to be more established companies with proven positive cash flow (that’s how they can afford to pay dividends). When the stock market crashes, the prices for these stocks go down as well, but their dividend yields go up. As their yields increase, this will attract investors seeking higher yields to buy these stocks.
Secondly, dividend payments you receive during the down market allows you to buy more shares to average down your cost basis.
To help prepare your portfolio, you could shift some of your investments toward dividend-paying stocks.
3. Sector Investing
The theory behind sector investing is simple. There is historical evidence that shows certain sectors do better than others in different phases of the economy. You could adjust your portfolio to take advantage of the economic cycle. Here is an illustration from Fidelity’s article: Sector investing using the business cycle.
If you agree with the Sector Investing approach, then you could over-weighing your portfolio toward Materials, Consumer Staples, Health Care, Energy, and Utilities; while under-weighing Consumer Discretionary and Information Technology.
4. Switch from Mutual Funds to ETFs
ETFs are much more tax-efficient than equivalent mutual funds. When the stock market crashes, investors invariably sell in panic. When a mutual fund is sold, the fund manager must sell the underlying securities to raise cash to meet that redemption. This creates capital gains that must be paid out to shareholders at the end of the year. If you have mutual funds in your taxable account, you could be stuck with a tax bill you didn’t deserve.
On the other hand, ETFs are bought and sold like stocks. This means there are no capital gains to worry about.
What to Do After a Stock Market Crash
Okay…the market took a dive, now what should you do?
1. Keep Investing
I invested through two major crashes so far — and they were BIG ones. Each time, all I did was keep adding more money to my portfolio. I didn’t panic and took out all my money. No, I kept it exactly where it should be…fully invested.
At the same time, I continued to contribute to my 401(k) plan as if nothing happened.
Personally, I feel this is the best strategy to invest through market crashes, corrections, and volatile markets.
If you follow the asset allocation strategy, a market crash should present an opportunity for you to rebalance your portfolio. This action will let you shift some money from investments that held up well, to investments that went down substantially. Although it might not be as appealing as rebalancing in the Bull Market, it accomplishes the same objective — buy low and sell high.
3. Tax Loss Harvesting
If you have investments in a taxable account, this is the best time to look at your investments to see if any asset has an unrealized loss. This might be a good time to sell these assets to realize the losses, which you can deduct against capital gains and up to $3,000 of your normal income.
Just be sure to replace it with another investment so that you don’t miss out on the gain when the market recovers. Also, be sure to avoid the wash sale rule.
4. Reassess Your Asset Allocation
If you utilize Tactical Asset Allocation or Sector Investing strategies, you should reevaluate if you have the right investment mix after the market crash. If you feel that the market will start to recover, then you should adjust your asset allocation to reflect the new market and economic conditions.
You should not let emotion drive your actions. It is not a good idea to check the stock market daily and react to every up and down. Ultimately, the worst thing you can do is panic sell right after the stock market crashes. If you are feeling nervous about the current market condition, consider implementing some of the strategies above to help you prepare for a stock market crash.
Always have an investment strategy and stick to it!
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.