5 things you need to know to prepare yourself for a market crash
Market crashes are a lot like those unexpected thunderstorms that always seem to show up right in the middle of something you've been planning for months. It's your kid's 10th birthday party. All of your family and friends have been invited. You've rented a water slide, filled up a million water balloons, and got all of the decorations set up perfectly. Everyone is so excited for the big day. And then...BOOM! Thunderstorm.
Like unexpected rain, market crashes are inevitable in the world of investing, and being caught unprepared when the storm hits can lead to devastating consequences. Our fight-or-flight responses can kick in and cause us to react irrationally and can actually worsen the impact of the crash itself.
Markets are Unpredictable
The first thing every investor must understand is that, unlike the weather, market movements are impossible to predict with any sort of reliability or accuracy. However, the most common questions I hear from investors are, “What do you think the market is going to do?” or “What stocks do you think I should invest in?”. Many investors unknowingly fall into what Mark Matson, founder of Matson Money, calls the Investor Prediction Syndrome™.
The fundamental flaw of Investor Prediction Syndrome™ is the underlying belief that, "In order to be a successful investor, I need a prediction or forecast about the future movements of the market." If the success of your investment portfolio depends on predicting the future, then you don't need to wait for a market crash. It’s already broken.
Turn Off the News
The news is not your friend. It is not their job to inform you about what is happening in the world. Their job is to draw in viewers so they can generate more ad revenue, and they primarily use negative news to do this!
Marc Trussler and Stuart Soroka of McGill University in Canada conducted an experiment where participants were asked to select from stories about political and economic conditions to read. They found that, “even though participants in the experiment said they preferred good news, were drawn to stories that were somewhat depressing”.
We are drawn to bad news like a moth to a flame. This Negativity Bias keeps investors in a perpetual state of anxiety and is the enemy of a positive investing experience. Turn off the news!
Know Your Risk/Return Preference
Many investors blindly accept portfolio recommendations from advisers without knowing how much they could actually lose during a down market cycle. Saying, "I'm a conservative/moderate/aggressive investor" isn't enough, and age isn't always a good indicator for risk tolerance. Just because an investor is young doesn’t automatically mean they would be an aggressive investor.
It is critical to know specifically and scientifically how much risk you are willing to take, and then understand what the long-term, expected rate of return is for that level of risk.
Diversification is probably one of the most important and least understood aspects of investing. How do you know if you are diversified? It’s important to understand that owning 10 stocks or even 10 mutual funds may not be enough. If I own a lot of stuff, that doesn't make me diversified. It just means I own a lot of stuff.
Thanks to the work of Nobel Laureate, Harry Markowitz, we can optimize a portfolio to reduce risk and increase return. The key to that is owning different asset classes. We use 21 different types of investment asset categories that react differently from each other during the same economic environment. For example, one asset class, like T-Bills, would likely remain stable during a stock market decline, thereby softening the negative effect of a market crash while still allowing you to capture the higher returns of stocks.
To sum it up, figure out how much risk you are comfortable with, then diversify like crazy.
Opportunity to Rebalance
Here's the good news: market crashes don't have to be the doom of your portfolio. Think of it this way. If I walk in the grocery store and see Oreos sitting in the Buy One/Get One section, I'm buying some Oreos. Using the same logic, when the market goes down, that means stocks are on sale!
Here's the bad news: unless you happen to have a large amount of cash sitting on hand, taking advantage of this sale will require you to rebalance, and that can be a very difficult thing for investors to do emotionally. As human beings we have a tendency to want to stick with something that has been doing well, but that mentality can cause us to miss out on massive opportunities for growth.
This is how rebalancing works. Let’s say in your portfolio, 50% of your money is in stocks and 50% is in T-Bills. Then, the market goes down. Now your portfolio is 40% in stocks and 60% in T-Bills instead. That's a problem, because your risk tolerance is set at 50/50; your portfolio is now out of balance. So, what do you do? You sell off 10% of your holdings in T-Bills and use that money to purchase more stocks, re-balancing your portfolio back to 50/50.
In the world of investing, preparation is the key to success. The next market crash will come, eventually. How will you prepare?
Understanding how investing works is vital for your success as an investor, and that comes from working with a coach who can help get you there. Our courses cover a variety of topics such as, Gearing Up for the Next Crash, Dismantling the Myths of Investing, and Mind Over Money, as well as the 2-day American Dream Experience.
Don't let yourself get caught unprepared. Register for Gearing Up for the Next Crash and see what other events are coming soon!
Gearing Up for the Next Crash
August 24, 2023, 6:00 - 8:00 PM CDT