First things first, we need to set some universal rules when it comes to discussing a stock market crash. I have 3 I will be enforcing in this article.
- Nobody knows when the next stock market crash will happen. News shows, finance wizards, and the occasional politician might try to convince you otherwise, but predicting the next crash is impossible. One of my idols Warren Buffet explained this point best… “Market forecasters are out there to make fortune tellers look good”.
- Timing the market is impossible. More than a few people think they can exit and reenter the market at the perfect time. Although this idea sounds good, it will almost never turn out that way. The reason for this is quite simple, you have no idea when the market has reached a high or a low.
- Finally, no action is necessary on your part. If you want to take precautions so you are prepared for a market crash you can. However, this is not required. When it comes to investing, especially in stocks, high amounts of activity by you can often be a bad thing. Emotion becomes a real problem when prices are moving up and down, which can lead to bad decision making. The best practice when investing is often to do nothing at all.
I’ll go through some of the key signs of market crashes and examples, then we’ll get into how to avoid the pitfalls of a market meltdown. You should also read our article Understanding The Stock Market if you are a beginner.
What is a stock market crash?
A market crash can sometimes be described as, a correction, a bear market, or a reverse trend. These terms generally all mean the same thing but it is important to understand what each look like and the subtle differences between the phrases. While there are no clear definitions of what each of these mean, this is what most people agree on.
- A Correction
This is a very frequent occurrence. It is a drop in share price of around 7-10%, which can happen to an individual stock, a certain industry, or even the broader market. Recently we saw a correction take place with the S&P 500 in December 2018.
The index had steady growth throughout 2017 & 2018. Then during December 2018, the S&P 500 corrected from $2,760 on the 30th of November,, to $2,416 on December 21st. This was a 12% correction which indicated the market was blowing off steam after an unsustainable run.
Since then we have seen the market steadily increase again… But we will never be able to tell when the next correction will take place.
- A bear market
A bear market is a less frequent occurrence. Over the last century, we have seen a bear market on average every 4 years. A bear market is a drop of up to 20% of the market price, what makes it different to a correction is, it usually takes more than a year to fully recover to its original price.
From October 2007 to March 2009 we experienced our most recent bear market, but my opinion is that this should be considered a market crash based on the effect on the US household.
From 1900 through 2013, there were 123 corrections (about one per year) and 32 bear markets (one every 3.5 years), according to Ned Davis Research.
- A stock market crash
The most infrequent occurrence is a stock market crash. Happening about every decade, this is a massive correction that exceeds a 40% drop. The bear market of 2007-09 resulted in a 54% drop in the Dow Jones Industrial Average. Before this, the last market crash happened in the early 2000s during the ‘.com bubble’.
A market crash is normally the result of unusual circumstances when a bubble has formed, or a serious political change occurs.
What is a bubble?
A bubble forms when a herd of people begin to invest in a particular asset. As more people invest, the market value increases, meaning the price drifts further and further away from the intrinsic value, or the underlying value of the asset.
Eventually, the price gets so out of control that people are no longer willing to pay it, and the buying pressure goes away. As the price tapers off, people begin selling, and the price starts falling. Then we begin the ‘blow off phase’.
Bubbles are usually formed around individual assets, but broad market bubbles have been seen before. An example of a market wide bubble is the US housing bubble which we touched upon earlier.
The most recent example of an individual bubble was in 2017 when the Cryptocurrency Bitcoin was introduced to the mass public. Bitcoin went mainstream and in January 2017, each Bitcoin was worth around $1,000.
As 2017 continued, the price skyrocketed and at the end of this Bitcoin bonanza, each Bitcoin in your wallet was worth just over $19,000 in December 2017. This level of appreciation is unheard of for any asset, hence the massive increase in price indicated a speculative bubble had formed.
People were so excited over this new digital currency that it led to hysteria in the market, and made people mad for Bitcoin.
The bubble burst at the end of 2017, and by February 2018 the Bitcoin price had reached a more sustainable price of $7,000. Meaning millions of people experienced a loss of more than 50% during the investment. This is the perfect example of a market crash, and how much damage it does to people who are uninformed about the investments they make.
From here we will be focusing on bear markets and crashes, corrections are something to take into account, but they happen so often with quick recoveries they shouldn’t affect your long term investment goals.
4 Ways to profit from a bear market
One of the easiest and safest ways to make money from a bear market, or any crash in the market is to wait until it recovers. The hardest thing in life is standing around and waiting for a turn around.
That being said, there are some strategies that will help you either accelerate your recovery, or give you new avenues to develop more income.
- Max out your Roth IRA
One thing that can be taken from the bearish market of 2007-09 is that, if you purchase index funds at regular intervals throughout the year via a Roth IRA, you’ll gather huge gains when the market recovers. It might sound risky as you aren’t sure when the market will rebound, but the more time you have investing in a lower index price the higher your gains later on.
If you want to know more about Roth IRA’s and why they are better than the traditional 401(K), check out What Is A Roth IRA: Why You Should Get One! Or if you’re coming in from the UK, check out What's The Difference: Roth IRA vs Stocks & Shares ISA.
In 2015, those who applied this strategy back during the 2007-09 bear market have made gains from cheaper shares bought during the slump. Now imagine all of the money made from the recovering shares bought during the crash, then all the shares bought as the index was recovering… That’s a lot of growth just in one investment account.
With all strategies, risk is involved. So don’t throw all your eggs in one basket, diversify your investments and check out the other game plans on this list.
- Find industries that tend to increase during a bear market
It may sound weird to think some assets actually do better in bear markets. This is why it is important to research past experiences of market slumps to see what industries went up, when everything around them was falling.
Numerous financial websites such as Bloomberg and Hargreaves Lansdown publish case studies based around different assets and sectors for different time frames.
A great example of this was during the bearish market after the very famous market crash of 1929-1933. Procter & Gamble prospered during this crash as they realised, even in a depression, people still need soap… The top 5 US soap companies during this time actually increased revenue over the 5 year period.
Bear markets can also have catalysts for companies that profit during a depression, so it would be wise to set aside a portion of your investment for companies like these.
- Buy bonds
Buying bonds is a great way to offset a bear market. Remember that a declining market typically occurs in difficult financial times. It often exposes which corporations have too much corporate debt to take care of and who is generally doing a pretty good job of dealing with their debt.
You might not be familiar with bonds, so I’ll give you the crash course to see if you’re interested.
There are 4 main bond types are:
- Treasury bonds which are issued by the federal government
- Municipal bonds are issued by cities, states, and regional governments
- Agency bonds are issued by government-sponsored enterprises like Freddie Mac or Fannie Mae
- Corporate bonds are issued by individual companies
You can buy these bonds either straight from the US Treasury or your broker. But some bonds are traded through ETF’s, such as the Vanguard Total Bond Market ETF (BND) which holds a lower cost diverse bonds.
- Look into stocks that pay dividend
Even though stocks are priced based on buying or selling shares, a dividend comes from the company's net income. If the share price drops but the company’s profit is still strong, you will be paid a dividend. This is what makes dividend paying stocks a great option in a decreasing market.
Finding dividend paying stocks is the core principle behind value investing. This is a more complicated investing strategy, so make sure you know what you’re looking at before buying random stocks.
Dividend investing is one of the best way to maximise your long term investments, see How You Can Retire Early By Using Dividend Growth Stocks!
3 Ways to survive a stock market crash
Stock market crashes very rarely lead to profits, one of the few examples I know of, where someone has made it big from a crash is during the US housing crisis, the movie ‘The Big Short’ explains how a few select people managed to manipulate the crash to favour them.
I’m not one of those Wall Street wizards that can tell you when the bubble is going to burst, and how to profit from it. That type of investing is an advanced strategy that most of us will not be able to implement.
Shorting the market is not attainable for the everyday investor, you need substantial financial backing and a trading license in whatever country you’re in to perform trades like that. So I’ll be going into how everyday people can survive a market crash then reap the benefits during recovery.
- Buy into good businesses
During a crash you want to invest in companies that have a solid track record of generating profit and attractive returns on equity. Some of the key areas to look at when reviewing a company is the debt-to-equity ratios, you want this to be a positive ratio, but during a depression don’t expect to see anything amazing.
You might also want to consider the gross profit margins, and the companies management of shareholders, as some smaller companies during a crash will not pay out to investors to improve cash flow.
Companies with friendly shareholder management, and good franchise value normally hold up better under stress, usually making a recovery even if the share price drops by as much as 75%.
Some companies that would fit this criteria are the Dividend Aristocrats. Which we describe further in our article: How To Retire Early With Dividend Growth Stocks!
- Follow a trusted formula
Dollar cost averaging is a strategy and formula used when moving into and out of your positions. By buying and selling at fixed rates and set amounts of money over the time you build your portfolio, it will allow you to avoid buying an asset at its peak, and selling at its bottom.
You are never going to be able to tell when a crash is coming, so the best practice is to stick to a routine formula of regular share accumulation so you hit the average market price for an asset.
- Reinvest your dividends
By reinvesting your dividends you will not only take advantage of compound interest on your earnings, you will also supercharge your dollar cost averaging formula.
The work of finance Professor Jeremy Siegel has shown time and time again, that reinvested dividends is a huge component of increasing overall wealth of those who made their fortunes investing in the market.
If you are just starting to invest, it may seem fun to withdraw dividends, but if you reinvest them, not only is your stock rising, your equity in the company is as well. That’s compound interest ON your compound interest.
No one hopes for a market crash or a bear market, but it doesn't mean we have to be scared of them. If everyone lost money during a collapse we wouldn’t have people like, Warren Buffet, Bill Gates, or Benjamin Graham.
We have such successful business people and investors because they always protect themselves. This is not a ‘plan b’ but it is a back up. You should diversify your investments and have a small hold that is cashed just in case of an emergency.
If you live paycheque to paycheque with no extra money to save, if you then lose your job you have no money to fall back on. For instance, the Berkshire Hathaway model from Warren Buffet is, if you live off your day job, then fund your retirement out of your regular salary. You need to build other cash generators (e.g., car washes, retail stores, newspaper routes, second jobs, royalties, rental houses, etc.) that you use to build your investment portfolio.
By using the Berkshire Hathaway method, you have a cash pot to fall back on if you lose your day job.
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