It is easier said than done to react to a market crash. Therefore, it is better to have your portfolio ready to withstand such a tumultuous situation before it actually happens.
The last decade has seen an environment of very low interest rates. It has dampened the returns investors can get from things like bonds and other fixed income. To maintain these returns, stocks have been the only game in town. This has created a market run where the shares have achieved very high premiums relative to the actual earnings and compared to the total equity.
It is foolish to try to say exactly when another market crash may occur. These are three steps that everyone can take to be ready for when that day comes.
Store in dry powder
The best way to deal with a market crash is to find a way to take advantage of it. Having cash available to buy opportunities that present themselves is the way to do just that.
Learn from Warren Buffett. Buffett plays some of his biggest games during volatility. He can do it because he keeps plenty of cash ready for use. He often talks about how inflation eats up the value of cash, however Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) tend to hold billions in cash when opportunities arise.
Cutting off some investments that have made big gains is a way to lock in profits while putting some cash in hand to be able to capitalize on a market crash. Conversely, trimming positions that have done poorly may be more tax efficient. Cutting losses is not always a bad thing.
2. Manage risk
Preparing for a market correction is very much about the quality of your portfolio. You can not necessarily just completely put everything on the sidelines and wait for a slowdown; especially if you are invested in retirement. What you can do is make sure you are invested in quality units. Many of the best possible names this year have been technology-related growth stocks. The market as a whole has become unbalanced in its haste to full-time high. Overexposure to equities based on growth moment or the total equity of the balance sheet may cause pain in your portfolio.
Find the weak links in your portfolio and remove them from the equation. Focus on safer stocks that can get you through.
3. Stay focused on the long term
Panic is everyone’s enemy. Just because your investments have fallen does not mean they will stay down. If you have bought healthy companies that are fundamental to long-term business success, do not worry about short-term turbulence. The investors who sold too much in the spring of 2020 are likely to live with some regrets.
If you see some things that are directly correlated with the crash, or a company that may be facing bankruptcy or irreversible damage, these investments may need to be dumped. Similarly, change in performance between stocks, fixed income, commodities, etc. requires similar adjustments. These moves will be much easier if your portfolio has already been reviewed and your risk reduced. Overall, it is important to stay cool and look long term.
Having some free cash ready and making sure your portfolio is not too risky are important things to keep in mind when the market is so high. At the same time, it is important to keep perspective. Long-term investors tend to do better when they do not over-adjust to a short-term market fluctuation. Over time, the market has only gone in one direction. Sudden shocks in volatility can make investors forget about it.