It’s going to happen.
It could happen tomorrow – or many years from now.
Perhaps it’s a sharp drawdown – or a painfully long journey that resembles death by a thousand cuts.
It could end quickly, like the March 2020 or the October 1987 crash. Alternatively, recovery could take years.
But the only thing that’s certain is that at some point, there will be a stock market crash.
I’m not saying this just because of all the madness that’s out there at the moment, though when I see WallStreetBets crushing hedge funds on GME or Robinhood traders discovering momentum trading it certainly makes me feel like 1999 all over again (and not in a good, youthful way).
Quoting a fellow finance blogger, stock market crashes are a feature, not a bug. Thus, if you are serious about your finances, you better have a plan to deal with a crash when it comes.
Today, let’s talk about some things you can do to prepare.
#1: Assess Your Exposure
While the stock market crash of 1929 set off the Great Depression, it certainly didn’t end that year.
As a matter of fact, the S&P 500 was only down 8% that year. It ultimately bottomed out in 1932, with a nasty peak-to-trough decline of 84%.
During the 1970s crisis, investors have seen a maximum drawdown of about 48%. The dot com bust had a similar decline of 49%.
Finally, the financial crisis was another whopper, with a 56% peak-to-trough decline.
It’s fair to say that we probably won’t have a repeat of the Great Depression. The governments and the central banks have learned a lesson or two in the past century.
That being said, you should probably assume the next stock market crash could temporarily wipe out as much as 50%-60% of your equity portfolio.
You should let that number sink in. Ideally, use it to update your net worth file. Stare at it for a while.
How does that picture make you feel? Importantly, how would your significant other feel about it?
If you are able to keep it together, well done to you.
But if the mere prospect makes you sick to your stomach, you should re-evaluate your asset allocation pronto.
And even more importantly, …
#2: Don’t Forget About Correlations
That is, the fact that the stock market typically doesn’t crash in isolation.
The decline is typically caused by an exogenous factor (pandemic, anyone?) – and is pretty much guaranteed to cause price declines across a range of other assets, from commodities to real estate to equity derivatives.
If you run a business, you may see a sharp drop off in client activity and revenues.
If you are employed, your company could fall on hard times – and decide to lay off folks and cut pay for those who remain.
You’ll need to form your own judgment here but remember – bad news never comes alone.
#3: Calibrate Your Spending
At times of market volatility, reducing your spending is one of the biggest levers you can pull to keep your finances on track.
Doing so immediately increases the “life span” of your emergency fund, offsets any reductions in your pay, and enables you to take advantage of depressed asset prices.
Most importantly, being able to flex your “cost base” downwards gives you peace of mind – because you know you’ve got options in case markets hit a rough patch.
Have a look at your budget (and if you don’t have one, start keeping one ASAP).
What are the “discretionary” costs you can temporarily do away with?
Can you chuck that expensive gym membership?
Find a replacement solution for your nanny/nursery (time to give granny a call?)
Skip that next holiday in favor of a staycation? (this one should be easy)
Identify your top 5 “emergency measures” and see how much of a difference that makes.
It will depend on your current spending patterns, but I know that for me, a 25% reduction is well within reach.
This is also one of the biggest reasons why spending on experiences trumps physical purchases.
Much easier to stop eating out for a while than to take that expensive BMW back to the dealership.
#4: Protect Your Earnings
On this blog, I cover a lot of ground writing about strategies for maximizing your earnings.
I am also a big believer in changing jobs as a tool for accelerating your pay and career progression.
No need to cover any of those topics again. Just remember – stock market crashes typically tend to catalyze changes that have been long in the making.
One could argue that changing jobs just before a crash can be dangerous. Last in, first out, and all that.
Perhaps. What’s even more dangerous is being stuck in a job that is slowly disappearing, courtesy of technological disruption or simply being tied to a shrinking industry.
In a downturn, these are the riskiest jobs to be in. They are the first on the cutting block when management is looking to revitalize and reposition their businesses.
Reinventing yourself is never easy – don’t make it any harder by trying to do so at times of severe market dislocations.
In other words, fix the roof while the sun is shining.
#5: Keep Investing
Everyone talks about it. Few people actually do it.
On the face of it, the FI community accepts the wisdom of continuing to put money to work in a crisis.
You take advantage of depressed prices, buying stocks on “fire sale”. When the market inevitably rebounds, it is these purchases that will give your portfolio a nitro boost.
And yet, as the experience has shown, very few people actually do it. When the world seems to be collapsing around you, you don’t need to go far to find an excuse.
This time is REALLY different!
But we’ve never had a pandemic / terrorist attack / [insert your own] before!
This is just the beginning – it’s all going to come down like a house of cards!
In other words, this:
What will YOU do in a stock market crash?
To make matters worse, people don’t just pause their investments. They also make the biggest mistake a stock market investor could ever commit.
As Morgan Housel says in his excellent book*, your success as an investor isn’t determined by what you do when the times are good.
Instead, it’s determined by your behavior in those rare moments when things are bad.
Other than simply holding your nerve, there are multiple ways to force yourself to stay the course in a crisis.
Automating investments is one.
The other one is to put a commitment device in place.
You can even hire a fee-only investment adviser who can steer your portfolio through turbulent times.
It doesn’t matter what it is. Just make sure you have a plan in place.
#6: Don’t Try To Time It
The threat of a market crash has been hanging over our heads for the better part of the past decade.
Below is a graphical summary of all the doomsday predictions made by famous economists and investors starting in 2010:
The vertical axis plots the absolute loss you would have experienced if you had taken their advice at the time and cashed out of the market.
Given this chart was prepared in 2019, you can increase the losses by another 10-15%.
Remember – no one can time the market. Not you, not me, not the smartest person in the world.
We all know the crash is coming – at some point. But investing like a correction is just around the corner is the worst thing you can do.
If you still don’t believe me, I encourage you to read this wonderful post from Personal Finance Club. It proves that steady investors end up ahead of perfect timers:
Yes, it may seem more than a little depressing to engage in a thought exercise alongside the above lines.
I mean, why in the world would you want to envisage scenarios that may have a catastrophic impact on your finances – and possibly your employment as well?
I’ve got a diametrically opposite perspective – because planning for a crash gives me comfort.
The comfort of having a decent sense of what the impact on my portfolio is going to be.
The comfort of knowing that I can flex my spending to ride out any volatility.
The comfort of knowing that I’ve done all I could to de-risk my employment.
Most of all, the comfort of knowing that I will take advantage of the depressed prices – and ultimately end up miles ahead of where I would be otherwise.
It’s a pretty good feeling. Give it a shot and see for yourself.
*Affiliate link. Read more about our affiliate policy here
About Banker On Fire
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Banker On FIRE is a London-based M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
Find out more about me and this blog here.
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