Remaining calm, knowing your investment strategy, and diversification. These are the key components that will help you survive a market crash.
Before going on to each of these stated components, it’s worth touching firstly on what a market crash is and what causes it. A market crash can be defined as:
a sudden dramatic loss of value of shares of stock in corporations. Crashes often follow speculative stock market bubbles such as the dot-com boom.’ (Source: www.investordictionary.com )
This definition is interesting as it includes an explanation of a common cause of market crashes, namely speculative stock market bubbles’. Speculation happens where punters take a gamble on a share, typically where they think that a sector is hot. Speculation is therefore based more on gut feel than on careful study of the fundamentals, and thus often leaves speculators facing stomach churning losses. Looked at this way, market crashes can, at least in part, be viewed as market corrections.
There is, however, one other important element that is always found where a market crash takes place panic. Institutional investors and private investors alike suddenly feel uneasy about their holdings and start to switch funds out of shares. This can suddenly create a stampede of frightened investors, many of whom are probably not particularly clear why they are stampeding. Various things can trigger the panic. It may be an economic indicator, or the threat of war.
A vital thing to realise therefore, before you even enter the stock market is that the market is not rational. For example: one day, you will be offered the option to buy a bank share at $6 and the next day at $4. In the meantime, nothing has changed about that company. They still have the same management and are predicting the same profits. In most cases it’s just that something has spooked the market.
So now that we know the typical causes of market crashes and that the market is not always rational. That is not to say that the impacts of a market crash can’t be severe. If you were just coming up to retirement and had shares worth $100,000 and then suddenly they were worth $50,000, you’d rightly be concerned. You might be a little less concerned if you knew that you had 30 years to go until retirement and were happy that your companies were fundamentally sound.
I’ve touched already upon the things that can help you survive a market crash. Let’s now look in a little more detail at them:
The temptation, when the market stampedes, is to follow the herd. Everyone’s selling BP so you sell BP. You bought the share $10 and you’re selling at $5, but you take the loss because you think the share price might go lower. Unfortunately, if you act like this you will probably never be a successful investor. You should be taking a deep breath and reassessing the logic that you used when you bought the share. Does the company still seem like a sound highly profitable company? If the company still seems sound and the drop in share price reflects general market jitters, then be prepared to ride out the short-term storm. And comfort yourself with the knowledge that there has never been a terminal market crash the stock market has always bounced back and the chances are it will this time too.
KNOW YOUR INVESTMENT STRATEGY:
To be a successful investor, you have to have a set of guidelines that you use when assessing whether to buy or sell a share. Personally, I like to follow a Long Term Buy and Hold strategy. I want good dividends along the way but I’m not really concerned about what the share price is now, or what it will be in two months, or even 1 year. I just want to remain confident that I have selected a company that will be successful in the long term and where I have a reasonable expectation that its share price will be substantially higher than my purchase price in 5, 10, or even 20 years time.
Selling a share because the whole market has dropped, or because the sector that my company is in has become unfashionable, doesn’t make particular sense to me. However, this approach is partly informed by my investment strategy. It’s possible that your strategy might be different and that there might be times when you’d sell a share to limit potential losses. The key is that you’re making a rational decision, based on the principles that guide your investment strategy.
When market crashes happen, the percentage falls are never uniform across the various sectors. There will always be some sectors that, for whatever reason, are particularly undervalued. Banks fall into this category at the moment, following the sub prime lending scare.
A way, therefore, to limit your downside on a market crash is to have a diversified portfolio. Buying into tracker funds is a good method to achieve this diversification. e.g. I buy into a fund that tracks the FTSE100 index. Banks would only be one fraction of all the companies in the top 100 FTSE index, and hopefully companies in other sectors (e.g. Telecoms) might balance things out to some extent.
I’m not saying that market crashes aren’t traumatic. We all like to monitor the share prices of the companies we’ve bought into, and it is psychologically difficult when we see (paper) value wiped from our portfolio. However, by remaining calm, staying true to your investment principles, and having a well researched diversified portfolio you stand a good chance of emerging undamaged when the stock market rebounds. Indeed, many shrewd investors view market crashes/corrections as an opportunity to buy good stocks at bargain prices.
A final couple of points to note. Firstly, you should not have all your money tied up in the stock market. It is always prudent to have a safe savings pot. Secondly, if you are approaching retirement and are relying on converting shares into bonds or an annuity to deliver a fixed income, then you should have already started to reduce your dependence on shares, so that a sudden downturn won’t leave you caught between a rock and a hard place.