As the old saying goes, there are two definitions in life – death and taxes. To that, we might be justified in adding a third – market crashes. Market crashes have been around for as long as the stock market itself, and every time they happen they make new winners and new losers.
This doesn’t happen randomly, though. Though market crashes are in themselves unpredictable, it’s possible to prepare for them. There are several tried-and-tested methods for protecting your 401k from stock market crashes, for instance, and even some that are used (with mixed success) to take advantage of stock market crashes.
In this article, we’ll focus on the defensive techniques. Here, we’ll take you through six ways you can prepare for a market crash, so you come out of the next one with your finances looking as healthy as they can. And then we’ll show you how you can use our platform – Wealthface – to plan and protect your investments.
The single most important way in which you can prepare for a stock market crash is to make sure that your investment portfolio is as diverse as possible.
Having a diversified portfolio is good advice at any time, because this reduces your exposure to risk. However, during “normal times” you may choose to purposefully expose your investments to increased risk in order to realize larger returns. That means that at these times, most active investors will hold their portfolio as individual stocks, stock mutual funds, or exchange-traded funds (ETFs).
If you see a crisis looming, it’s important to be able to move a good proportion of that money into safer investments. That can include pulling the money out of the stock market altogether, and keeping it in a high-interest savings account. But it should also mean that you diversify the types of assets you hold as much as possible. Ideally, your assets should include all of the major stores of value available to you – stocks, bonds, cash, real estate, derivatives, cash value life insurance, annuities, and precious metals.
The key here is to strike a balance between long-term investment and flexibility. While the highest returns can generally be realized by keeping your money in a particular investment for a long time, you shouldn’t let this get in the way of your flexibility. That means that you need a platform that will allow you to quickly buy and sell shares, such as Wealthface. Wealthface also offers a range of tools that can allow you to quickly balance your portfolio during good times, and get out quickly if you see a crash looming.
These features mean that Wealthface can help you to avoid the worst of the next stock market crash, because you can easily and quickly move assets to where they are safe. To get started with Wealthface today, click the link below:
2. Fly to Safety
A second strategy for dealing with stock market crashes is to have an exit strategy for when a crash starts to happen.
Here, you can imitate the professionals in order to protect your investments. When a stock market crash starts to occur – as evident in the rapidly falling price of stocks, for instance, or financial institutions going bust – this generally triggers a race. Professional investors will pull their clients’ money out of the stock market by converting it into less volatile forms of value.
The two most common of these are precious metals and cash. Gold, for instance, spikes in value every time the market is spooked by rumors of a crash, because many regard it as the most stable form of long-term investment. Cash is a close second to precious metals, because it generally holds its value even during the most far-reaching crashes, as long as the currency you are holding is backed by a large country like the USA, Japan, or the UK.
It’s possible for individual investors to follow this example, and quickly divest themselves of volatile assets as soon as they see a crash occurring. It’s crucial, however, that you know how to do this. Take some time to research how to buy precious metals, and make sure that cashing out your shares won’t land you with a massive tax bill. That way, when the next crash does occurs, you’ll know exactly what to do, and won’t waste precious days in research.
3. Get a Guarantee
There are some types of investment – known as guaranteed investments – that won’t crash with the stock market. This is because the companies who offer them are legally obliged to pay out a particular return, even in the event of a stock market crash. The downside of these investments is that the returns on them are very low.
This means that most investors won’t want to hold guaranteed investments as a large part of their portfolio. That said, having some money in these instruments can be a good way to protect a portion of your assets in the event of a crash. They can also provide a short-term lifeboat for your money as the market starts to crash. For this kind of short-term approach, bank CDs and Treasury securities are a good bet.
There are longer-term ways to invest in guaranteed assets, though, and some of these offer reasonable returns as long as you are willing to hold them for many years (or even decades). Fixed or indexed annuities or even indexed universal life insurance products can provide better returns than Treasury bonds, and can provide a good income even during stock market crashes.
Hedging is a widely known, and widely misunderstood, way of minimizing the impact of a stock market crash on your assets. Hedging is a technique in which you essentially “bet against” shares, and most commonly against shares that you already own.
This works because it allows you to profit from a stock reducing in value. Depending on the mix of standard and hedged options you hold, this can either mitigate some of your losses, or (in rare cases) even profit from a market downturn.
It’s even possible to use hedging to profit directly from stock market crashes – this is part of the strategy of hedge funds. However, you should be advised that this is a very risky strategy even for those with an encyclopedic knowledge of the stock market, and so definitely not recommended for individual investors.
That said, there is one method of hedging that is relatively straightforward, and that even amateur investors can take advantage of – put options. These derivatives will increase enormously in value if the price of the underlying security or benchmark drops in value, which it definitely will if we enter a broad-based market crash.
5. Pay Off Debts
A quick word about debts, which investors often forget about in the chaos of a market crash. If you are holding high-interest debts when you see the market about to enter a crash, you should quickly use any available liquidity to pay them off.
This is for two reasons – one short term and one long term. In the short term, it’s a good idea in times of economic hardship to reduce your monthly outgoings, such as your mortgage payments. Getting rid of your debt also makes sense on a macroeconomic level, though. This is because, in the immediate aftermath of a stock market crash, central banks tend to raise interest rates so that financial institutions can recoup some of their losses.
If you hold high-interest consumer credit such as credit cards, these interest rate increases can really hurt. So while it’s a good idea to minimize debt even in normal times, it’s especially important in the run up to a stock market crash.
6. Make the Most of Losses
Finally, it’s important to recognize that you can never be completely safe from a stock market crash. No matter how well diversified your portfolio, and how quickly you can get your assets to safety, a broad enough crash will always hurt you at least a little.
There are ways of making the most of that, though. Specifically, if you are clever about when you accept these losses, you can use them to offset profits in another year, and thereby reduce your tax liability. Tax-loss harvesting, for instance, is one option for losses sustained in taxable accounts. You simply sell all of your losing positions and buy them back at least 31 days later. (That means selling before the end of November to realize the loss before Jan. 1.)
The Bottom Line
There is no completely reliable way to predict stock market crashes, and similarly there is no completely fool-proof method for avoiding losses that can occur during a crash. What you can do, however, is to prepare for the worst.
By using a platform like Wealthface, you can build a diversified portfolio that will put you in a good position to weather the storm of a stock market crash. Then, if and when a stock market crash does occur, you can also use our platform to get your assets to safety quickly.