Updated March 30, 2021
Written by The Motley Fool Staff
Are you worried about a stock market crash?
As terrifying and discouraging as a market crash can be, it doesn’t have to knock the wind out of you: you can be prepared. How does that work? Let’s take a closer look at stock market crashes and find out how you can prepare for a market downturn.
What is a Stock Market Crash?
A stock market crash is a sharp decline in the value of stocks, one that happens over a single day or week.
A crash is not a correction, which happens when stocks stumble by at least 10% (but no more than 20%) of a 52-week high over several days, weeks and months. Nor is it a dip, a fall of 5% to 10% from high prices, which can happen several times in a day.
A crash is more dramatic than these, causing the price of stocks in major indexes to snowball into double-digit losses over a very short period of time.
What Causes a Stock Market Crash?
To put it simply—a whipsaw of bad news and panic.
Here’s what usually happens: a catastrophic event—a natural disaster, economic crisis, global pandemic —causes mass panic on the stock floor. Investors, believing such events will destabilize the financial future of the companies whose stocks they hold, sell their shares to protect themselves from further losses. As more and more investors rush for the emergency exits, supply exceeds demand, prices nosedive and a crash becomes unavoidable.
A market crash usually comes after a period of sustained growth. When the economy is strong, when unemployment rates are down, when traders are feeling optimistic, they’ll buy more shares, hiking prices upward. At a certain point, these prices no longer reflect the financial strength of the companies they represent. They become, in short, unstable. At that point, all it takes is one unexpected event to blindside traders and cause the mass panic that brings prices way down.
Is a Market Crash Bad?
Nothing can knock the wind out of a self-confident trader more than a stock market crash. But stock market crashes aren’t necessarily bad. In fact, you might actually make money in the long run, if you’re smart.
Here’s the thing—a stock market crash is only as bad as your reaction to it. Sure, no one would say a stock market crash is a pleasant experience, but you only lock in losses when you sell your stocks. If you can resist the urge to sell, you can prevent a bad situation from becoming a verifiable loss of wealth.
What Should You Do When a Stock Market Crash Happens?
We’ll go ahead and tell you: if you don’t think you’ll experience a stock market crash, history isn’t on your side. Chances are you’ve already lived through the latest one (the coronavirus crash) and you’ll probably experience a handful more in your lifetime. So, when a crash does happen, you don’t have to throw your hands up and surrender. Here are three ways you can make it through any crash.
1. Refuse to Panic-Sell
Never, never, never sell stocks out of fear.
That’s a surefire way to lose money. In fact, selling at prices lower than what you paid is the only way to lose money in the stock market. When you feel the urge to sell, remind yourself that market crashes are typically short-lived and, by staying invested, you’ll get the full force of the market recovery.
Before you sell anything, do your research and make an informed decision. Don’t let emotion take over.
2. Think Long-Term
Make no mistake: stock market crashes are emotional, stressful and heart-wrenching.
Shifting your thoughts from the here-and-now to the future reminds you that the game isn’t over, and you have plenty of time to recover. Turn off the news for a while, resist the urge to check your account balances and delete your investing apps if you have to.
3. Buy Quality Stocks
Yes, instead of selling, take advantage of the low prices and buy quality stocks. Sure, it’s hard to buy stocks in a crash, especially since you’ll probably experience more losses in the short-term. For those who pull the trigger while the market is choppy will see generous returns when the market stabilizes.
One way you can stay informed and make wise investments is to sign up for Stock Advisor, where we provide two new stock picks each month and a members’ forum where you can consult with our community of investors during market volatility.
How Can You Prepare for the Next Stock Market Crash?
It’s been almost a year since we saw the last stock market crash—a heart-wrenching 36% drop in the S&P/TSX—and already analysts are warning another crash is imminent. That can seem a little terrifying, not to mention discouraging, especially if you’re finally picking yourself up after a year riddled in emotional lows.
The reality, however, is no one knows when the market will crash again, no matter what their market analyses says. Nor does it really matter for most traders. You don’t have to know when the next stock market crash will happen to be prepared. Do these things right now and you won’t feel sucker-punched when a crash happens.
1. Build an Emergency Fund
An emergency fund gives you peace of mind when the going gets rough and it helps you resist the urge to sell stocks and stockpile funds. You should aim to have at least three months’ worth of liquid cash in a secure account.
Note: this isn’t money tucked away in investments or growth-oriented accounts with limited withdrawal access, such as annuities or CDs. Your emergency fund is a stockpile of liquid cash that you can access fast.
2. Rebalance Your Portfolio
When you rebalance your portfolio, you buy or sell stocks to maintain asset allocation, which is a fancy way of saying you’re balancing risks with rewards.
For example, let’s say you want 65% in stocks and 35% in bonds (this asset allocation would be a less aggressive strategy). Let’s further say stocks go up and your allocation to them rises to 82%. Given the risks of market volatility, you may not be comfortable having that much in stocks.
So, to rebalance, you sell stocks until you’re back to 65%.
3. Make a Stock Wishlist
Which stocks would you want to add to your portfolio if their prices weren’t so high? Start making a list now. Put aside extra cash and when prices are low, see if your dream stocks are affordable.
Similarly, now’s a good time to sell stocks you don’t want anymore. Some companies in your portfolio may have lost their competitive edge, or you may have too many stocks in one industry. Either way, take a close look at your stock portfolio and see what you can sell right now before the market dives.
4. Don’t Worry About Timing the Market
When you time the market, you buy stocks when prices are low and sell them when prices are high. Sounds smart, right?
Truthfully, it’s nearly impossible to time the market correctly and you may find yourself locking in losses and missing out on gains. Instead of trying to time the market, invest consistently. Keeping a long-term perspective and staying invested day-in, day-out, is hands down the best strategy for building wealth.
5. Keep an Historic Perspective
Lastly, remember—every market crash has a market rebound. No matter how low it dips, the market will recover. No stock market crash has ever—ever—resulted in permanent losses. As our buddy Heraclitus said, the only constant in life is change. And yes: that change can be upward.
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