What to Do When the Stock Market Is Crashing
Stock market crashes can be terrifying for investors, especially when you have a large allocation of your investment portfolio in the stock market. This guide will cover all the right and wrong moves for when the stock market crashes and give you the confidence to execute the best investment strategy possible.
Between 2020-2022, I made over 35% returns by following these tactics in the volatile stock market crash resulting from the Covid pandemic. Previously in 2008-2009, during the great recession, I was a floor trader on the New York Stock Exchange and made millions a day for my firm by understanding the dynamics of liquidy and fear.
The more you understand the process, the better you will be prepared and confident that you are making all the right decisions. Stock markets are primarily a test of confidence and behavior, so being prepared and knowing what to do will keep you from folding under pressure.
What Is A Stock Market Crash?
A market crash is when stock prices rapidly decline across a broad market or sector. A market crash is usually caused by new data or information suggesting the economy is distressed. Often a knee-jerk reaction causes a sudden drop because investors and traders assume that all companies will suffer.
However, not all companies are created equal, and most often, in a stock market crash, the baby gets thrown out with the bathwater.
Although stock market crashes are often frightening for investors, they provide great opportunities to buy quality companies at deep discounts. When grass-fed ribeye steaks and fresh Alaskan king salmon go on sale at my supermarket, I buy extras and throw some in the freezer.
Top Dollar Edge: The most important thing to understand about the stock market is that price is what you pay to buy or sell a company, but the value is based on future earnings and growth potential.
Calculating valuations is a complex task because there are numerous models and variations. Even professional wall street analysts often disagree over valuations for the same company. Generally, determining values includes firm-specific factors as well as macroeconomic variables such as interest rates and consumer spending. In a crash, fear takes over, and prices will get crushed to unreasonable levels for some companies. This is when a smart investor should be holding steady and buying.
What Do I Buy?
Before you start worrying about company-specific valuations or economic signals, consider this: most of the errors made in a crash have nothing to do with technical models or investing strategy. Almost all the challenges and mistakes come down to psychological and behavioral decisions.
The goal for long-term investors is to buy high-quality companies that will weather the storm. Do not double down on companies that are speculative or have never been profitable.
If you don’t understand company valuations or financial statements, don’t sweat it. In this case, I recommend buying diversified large-cap passive index ETFs, such as VOO. This fund replicates the S&P 500, and most of these fortune 500 companies will come out the other side unscathed.
The more you understand and trust in the normality of a stressful crash, the more likely you will make the correct decisions and come out pleased with your actions in the long run. Unlike most things in life, the mentality of a crash is reversed- if it feels wrong, you’re doing it right.
How Long Does A Market Crash Take To Recover?
Historically, market crashes can be quick corrections or long-term bear markets, which can continue to grind lower and lower over time.
Corrections are often caused by temporary fears that can have an immediate sudden drop in the market. Causes could be anything from a military threat to an economic sanction or even a surprise economic data point that catches investors off guard. Basically, corrections occur because the market reconsiders the stability of the economy and the future growth potential of companies.
Dip buyers believe they are buying into a quick correction and usually act more as short-term traders than investors. The risk of buying the dip is that it’s just the tip of the iceberg, and the market may continue spiraling into a bear market with more evidence of an economic slowdown.
I do not advocate ‘dip buying’ with additional allocations than you would during ordinary market conditions. The danger is that if you over-allocate early in a crash, you will find yourself in a target allocation that is not in line with your investment plan and find yourself with no strategy if the market moves lower.
A bear market is defined as a decline in the stock market of 20% or more. Bear markets often create a form of psychological torture where there is no end in sight. Intelligent investors should never sell investments in this environment or give up on the market. Remember that the market is cyclical and always bounces back (if you give it enough time).
The market moves in a long-term cycle as investors reassess their portfolios, often based on how the market is performing. In good times people think the market will never go down, but nevertheless, every once in a while a major crash seems to shock and shake investors’ morale. To be a successful investor, you need to have a long-term outlook and be mentally prepared to weather the storms.
The hardest part of any investment decision always occurs at the extreme points of the market cycle. When the days are the darkest and the market looks bottomless, this is always the most difficult but advantageous time to buy. On the other end, selling even a small part of a long-term position is always challenging when the market is roaring higher and higher in a bull market. In the same manner that an oversold market is often the best time to buy, an overbought market (with frothy valuations) is usually an excellent time to trim positions and rebalance your portfolio.
How Low Does A Crash Usually Go?
No one can predict the bottom of a crash. The unknown breeds fear, and you will almost certainly feel like the market can only go lower. Let’s take a look at historical crashes to understand how low the markets have gone in past crashes.
So what can we take away? Unfortunately, there is no perfect model and no way of accurately predicting how low the crash will drop. Not the definitive answer you probably wanted. Nevertheless, here’s what I suggest for your game plan.
If we stay disciplined and don’t prematurely “buy the dip,” we should always start buying a little once the market has officially hit bear territory, at 20% down. You want to take the free cash you have available to invest and break it up into, say, eight to ten equal chunks. I recommend buying in chunks as the market falls to about -35% to -40%. I usually buy a bit more every 2-3% lower, and by -40%, I will be fully committed with no more ammunition.
These purchases will always prove to be a good investment in the long run and will significantly outperform the past century’s 8.5% average annual stock market returns. Are you feeling good about double-digit returns? Then start buying these levels and thank me later.
Before you start worrying about the market going potentially lower, just remember that you will never be able to time the absolute bottom, unless you are a wizard. Maybe you buy a bit too early, but at least you will have purchased stocks at great long-term valuations! Focus on knowing you will be happy in the long run to have had the opportunity to buy at these prices and try not to focus on temporary paper losses.
Be careful not to wait and attempt to time the bottom of the market. Waiting is the most common mistake, and inevitably, the market rebounds upwards. Sadly this often fools investors into believing it will be the beginning of the rally, and then they buy stock higher than it had just previously been. Often in these periods of volatility, the market will bounce around and taunt you, don’t take the bait. I’ve seen smart people do this repeatedly only to curse themselves over and over, don’t be that fool. Keep it simple, and don’t try to overthink the news or time the bottom.
Some of the most significant single-day rallies in the stock market directly follow the largest crashes and sometimes are the beginning of the next bull market. You never know, but are always better off buying before those large rallies occur.
How Can You Prepare For A Market Crash?
No one can accurately predict an imminent market crash. If I could, I would be one of the wealthiest investors in the world and would probably be on my yacht right now. In some rare cases, some successful investors have become famously rich by predicting a single market crash. However, this often requires both luck and immense skill, and the predictions have never been repeated by these individuals with regularity.
Common signs that often signal economic weakness include:
In reality, these warning signs often appear a bit too late. Once multiple symptoms confirm these theories, the market will likely have already dipped significantly lower. Nevertheless, there have been times when economic signs have flashed red, and the markets still traded at their highs.
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Let’s assume you are not Paul Tudor Jones (the billionaire fund manager who predicted the 1987 crash) or channeling any psychic energy.
In the beginning phases of a market downturn, there will usually be increased market volatility. During this time, the prudent investment strategy is to simply stick to your investment plan. Your investment strategy should include continuing to buy stocks, mutual funds, or any other index funds you would ordinarily purchase using dollar cost averaging techniques. Your investment strategy and target allocation should not change until the market declines to 20%.
Once the market reaches 20%, it is officially a bear market. Now is the time to start allocating any additional cash you have on the sidelines. Any free money (available to invest long-term) should be divided into eight to ten chunks and slowly allocated as the market drops, purchasing additional shares of diversified ETFs or stocks every few percent lower.
Effectively you are dollar-cost averaging your additional allocations using percentage moves instead of time. This makes better sense in this environment because your goal is to increase allocation because of the discounted prices of stocks and ETFs. While others are panic selling, the long-term investor will be increasing the asset allocation of their underpriced assets.
Other Considerations and Tactics During a Crash
Review Your Investment Plan and Target Allocations
Consider your investment plan and how much allocation you are comfortable with in risky assets such as stocks. If you are young or have many years before you will need the money, consider this a reasonable time to increase your risk tolerance, as any returns will likely be outsized over normal circumstances. Your risk vs. return potential gets better the lower the market drops.
Rebalance Your Portfolio
Even if you have no free cash on the side, you can still make increased returns by rebalancing the target allocations outlined in your investment plan. A market crash is the best time to rebalance your portfolio and use the profits on appreciated assets to purchase undervalued stocks.
In a stock market crash, many investors flock to government bonds and corporate bonds, which are considered less risky assets. A market crash is not the time to reduce risk tolerance, but rather you can often take advantage of this favorable financial situation by selling your bonds at overpriced valuations and buying stocks on the cheap.
Tax Loss Harvesting
Tax loss harvesting is a strategy whereby you offset your tax liabilities (unrealized capital gains) with capital losses.
Assuming you are regularly investing, during a crash you will likely have some recent investments, which are now capital losses. A savvy investor should consider harvesting these losses during a decline, however, you should always reallocate all the proceeds to new investments immediately. The goal is to sell and rebuy a similar asset simultaneously in order to achieve minimal change (ideally zero) to your investor allocations, but only to harvest a loss.
The benefits of these harvested taxable losses are that they could be used immediately (in the same tax year) or carried forward indefinitely to offset future gains from rebalancing or profit-taking.
Top Dollar Edge: Harvested tax losses can offset $3,000 per year against ordinary income if you don’t have any capital gains to offset. Any amount over $3,000 will be carried forward indefinitely and can be offset again in the following year(s).
Don’t Trade on Margin
I never recommend trading on margin for anyone except a professional who fully understands the implications of leverage. Trading on margin means taking a loan from your broker in order to invest more than you can actually afford. Sounds dangerous? It can be extremely costly, and the worst part is that your broker could choose to close your positions at the market lows if they feel your account is getting too risky.
Market crashes can be very stressful as you watch your losses add up and worry about the impact on your net worth.
Here’s a recap of what to do correctly:
Josh is a financial expert with 15+ years on Wall Street as a senior market strategist and trader. Josh graduated from Cornell University with a business degree in Applied Economics and has held numerous U.S. and European securities and brokerage licenses including FINRA Series 3, 7, 24, & 55. In addition to running an investment and trading firm, Josh is the founder and CEO of Top Dollar, where he teaches others how to build 6-figure passive income with smart money strategies that he uses himself.