Stock Investing: Preparing for a crash

The stock market does not always rise. We know it, we fear it. Many investors are kept on the sidelines, or kept from committing wholly to their portfolios because of the uncertainty, and because of the memory. I got killed in the last big market drop. What if I blow the timing and invest just as the next fall comes? 

Over the past 100 years, the stock market has offered higher returns than just about any other asset class. And if you're choosing the companies you invest in-- researching them as I've discussed here: vetting their performance, their management, their products and their competitive edge-- then you have substantially improved odds of doing even better.

US stocks have now enjoyed more than a huge 6 year bull market. In that brief time the S&P 500 stock index, a standard measure of the broader market, has risen over 200%.

But it won't last forever. In fact, the market has made almost no headway at all since the start of 2015. It could see a correction, or a short drop, anytime. We could even get into "bear" territory, during which the index falls 20% or more. What many people don't realize is that this necessary from time to time in order to eliminate the excess confidence and money in the market that has accumulated since the last downturn. Think of it like a forest fire: massive tree damage and scorched earth, but ultimately essential to clear out the deadwood and put nutrients in the soil for new growth. 

How does one prepare for such an event? There are three general approaches, and each has its advantages and disadvantages.

Option 1: Sell everything. In this scenario, I’ve decided the market is just about to plummet, and I want to protect my gains over the past few years so I sell my holdings to cash and wait for the market to do its thing and then rise again. At that time, I tell myself, I will repurchase my holdings at a big discount and hold them until the next drop.

chart from AspireByTCI.com

This plan requires several incorrect assumptions. 1: I will know the top. It is, of course, totally absurd to think that I will know when the market has peaked. There is no bell or warning light that things are about to take a turn. The list is long of supposedly wise and experienced managers who thought the fun was over and sold out prematurely to lock in gains. Imagine if you sell and the market continues on to far greater heights? You’ll have missed it, and you’ll have no discounted entry point at which to reinvest. 2: I have no problem paying 15-20% or more in capital gains on my sales. Remember, a long-held stock is an asset and there are no taxes until sale. If you plan to sell a winner and face the tax, I would hope its because you have a better place for the money, one which is so valuable to you that it's worth the capital gains on your stock sale to get the money to pay for it. 3: I will know when the market hits bottom so I can buy back in. How will you know? Did you know when the Great Recession ended? Did you reinvest in March 2009? Hindsight is 20/20 but in the moment few can see a shifting tide. And if you aren’t sure when to reenter, what will be the catalyst for you to do so? Again the list is long of wise and experienced managers who went to cash in 2007 but didn’t fully recommit until 2010 or later, missing most of the market's early recovery.

Option 2: Do nothing. Here, I have wisely recognized that the market is more often up than down, climbs higher than it falls, and that the downturns always hit bottom eventually and start to climb back. If I sell to protect my gains I will just worry about the right moment to sell, the taxes I owe and then the timing to get back in. So I'd prefer to do nothing at all.

This is not a terrible way to go. Generally speaking the assumptions are correct: when the market has fallen and then recovered, and all is said and done, your diversified portfolio will be pretty much intact.

That hurts

The primary disadvantage to this method: pain. You will watch your assets drop in value, often very substantially, and you’ll feel the pull to sell them and stop the bleeding. Worse, your friends and colleagues will tell you stories about when and how they got out and they may even say you’re nuts to try to ride it out. You’ll worry that you’re throwing your savings away, or burning the kids’ college fund or your retirement. You’ll feel foolish and arrogant for not listening to reason. You may have to defend your decision to a spouse or a parent. If the downturn continues, you’ll begin to question yourself, as well. It’s a difficult ride.

Option 3: Keep the winners, sell the losers. This approach splits the difference between the first two options, and it’s a good exercise in emotional discipline and forward thinking. Here, I maintain my holdings if they are higher than my purchase price and I sell any stocks which have fallen since purchase. 

Presumably, you're holding onto some stocks that have gone against you not out of stubbornness or pride, but because you believe they will turn around and rise. But if you believe the market will head downward before your losers come back up, theoretically putting those stocks deeper into the red, why not sell them to protect yourself? As there are no taxes when there are no gains, you can sell the losers without penalty beyond trading costs. And holding on to the winners and riding out the storm means no capital gains tax there either. 

The primary disadvantage to this approach is, again, the pain of watching your assets reduced. But I find that to be more than offset by the key advantage: you now have cash from the sale of those losers with which to buy the newly discounted companies you’ve been watching. You will not know the precise timing to buy those, of course, but generally speaking that’s not critical since you know the market overall will recover and the prices are temporarily lower. Don't try to be perfect; a good deal is a good deal.

In the end, the market downs are a necessary evil to make room for new growth. Do not fear them. Look at them as buying opportunities-- everything on the discount rack-- and try to use them to pick up a couple companies you did not previously own. Your overall portfolio returns will be much healthier as a result of your strong stomach and your commitment to the long term. 

Drifting to Fifty | Random unrelated nugget of the week
Never loan money to close friends or family. If the loan comes between you later it could ruin a critical relationship. If your best friend or your sister needs cash, give her the money. Maybe someday she will repay you, and won't that be a lovely surprise.