on june 13, the s&p 500 index ended the trading day in a bear market. still, the milestone was not as dramatic as the stock market crash of March 2020, when covid-19 caused chaos in markets around the world.
But there are many reasons why you may be worried that stocks will continue to spiral down, including continued runaway inflation and supply shortages, further interest rate hikes, and the war in Ukraine.
The difference between a bear market and a stock market crash is not exactly precise. both are defined as a 20% drop from the most recent stock market highs. But a crash usually happens quickly, while a bear market is a prolonged period of decline. In 2022, for example, stocks have gradually slipped into bear market territory after hitting an all-time high in January.
First, the bad news: yes, the stock market will crash again at some point. Stock market crashes are completely normal. from 1929 to 2021, the stock market crashed 21 times. it is inevitable that it will fail again. we just don’t know when.
now for the good news: historically the stock market has always recovered over time.
If you start preparing now, your finances will also bounce back the next time the market crashes.
5 ways to prepare for a stock market crash
The problem is that many people don’t start thinking about how to prepare for a stock market crash until after the market has already crashed. that’s not exactly helpful advice when we’re already in a bear market. but no one knows how much further stocks may fall.
You can still take action now to mitigate damage later. however, in many situations, the best course of action will be to wait.
1. don’t try to time your exit
Some people try what is known as market timing, which means they try to cash in on their investments before the market crashes. or they don’t invest when stocks are rising because they think the market is overvalued.
the problem is that not even the best minds on wall street can predict the ups and downs of the market. the stock market could be active for a long time. If you avoid investing out of fear or because you expect to buy when the market falls, you could lose significant profits. And if you withdraw after the stock has already fallen, you will lose money or seriously decrease your profits.
A better strategy is to practice dollar cost averaging, which means you invest a fixed amount at regular intervals. If you invest in a 401(k) or similar employer-sponsored retirement account, you’re already doing so because you’re investing money from every paycheck. The same is true if you automatically invest each month in a Roth IRA or a Traditional IRA. over time, dollar cost averaging tends to produce better returns than trying to time the market.
2. create your emergency fund
An emergency fund is the best investment you can make if you’re worried about a stock market crash. You need a cushion of cash in case you are hit with a big expense or job loss right after the market has crashed. Otherwise, you may need to dip into your 401(k) or other investments before they’ve had time to recover. if you’re under 59½, you could also face early withdrawal penalties.
If you don’t have at least a six-month emergency fund, make creating one a high priority. Of course, this is a long-term goal that can take years to achieve. but any safety net you can build is a win.
Try to budget at least 10% of your salary for emergency savings. if that’s not feasible or you want to speed up your progress, taking an extra hustle to build up your reserves is a good strategy.
If you’re nearing retirement or have already retired, it’s especially important to make sure you have ample cash reserves. An untimely crash can devastate your retirement plans by forcing you to sell investments before they’ve recovered or claim Social Security too soon.
Consider meeting with a paid financial advisor if you are retired or plan to retire in the next five years. they can help you determine how much cash you should have on hand and whether you have the right ratio of stocks to bonds.
While retirees often want a higher concentration of bonds than someone with a decade or more to go in retirement, rebalancing after a stock market crash is not a smart move. If you’re retired and need to withdraw money, to pay expenses or due to required minimum distributions (RMDs), you’ll usually want to sell bonds rather than stocks to avoid substantial losses. after the stock market recovers, you can rebalance your portfolio.
3. limit individual stocks to 5% of your portfolio
Maintaining a diversified portfolio is essential to weathering a stock market downturn. If you invest in stocks of individual companies, try to limit any individual investment to no more than 5% of your overall portfolio.
Whenever you invest in stocks, you risk losing money just because the market is down. But the risks of investing in individual stocks are greater compared to investing in index funds that move up and down with the stock market as a whole. for example, there is the risk that one industry will be particularly affected, as was the case with tech stocks during the dot-com crisis, and risks specific to one company, such as poor management decisions or increased competition.
4. rethink risk investing
If you’ve made a lot of money in the past with risky investments like cryptocurrencies or penny stocks, think carefully before investing more. There’s nothing wrong with investing a small amount of money in a high-risk investment, as long as you have adequate savings and don’t have high-interest debt. But these investments are much more volatile than the stock market in general, so your losses could be especially steep.
5. decide now if you want to invest more
A stock market crash can be a great opportunity to invest more if you have the stomach for it. As long as you have a solid emergency fund and are investing for retirement, you could set aside extra money to invest when the stock market crashes.
Because it’s natural to panic when stocks plummet, make a plan now. For example, you might decide to invest $x extra if the S&P 500 falls below 3,500. Or if there is a stock you want to buy, you might decide that you will buy it if the price falls below a certain level.
This may seem contradictory to what we said about not trying to time the market. To be clear, saving money to invest when stocks fall is a strategy you should use only if you’re already dollar cost averaging when investing for retirement. But if your finances are in good shape and fit your risk tolerance, it’s okay to be prepared to hunt for bargains the next time stocks crash.
what should you do when the market crashes?
probably nothing. A stock market crash is panic-inducing, but it’s best not to make important money decisions from a place of fear. keep investing in your 401(k) after an accident unless your financial situation has changed dramatically. avoid checking your account daily.
It’s never nice to see your net worth plummet. But if you don’t sell your investments at a loss, you haven’t really lost any money. With time and patience, your finances will eventually recover.
robin hartill is a certified financial planner and a senior writer at The Penny Hoarder. She writes Dear Penny’s personal finance advice column. click here to sign up for dear penny’s newsletter.