Stock market crashes have happened several times throughout history, and crashes in the future are all but guaranteed. These sharp declines in share prices are a scary concept for most investors.
The good news is that although market downturns can be painful, thoughtful planning and execution of investments — even during these times — can yield positive results.
What Is a Stock Market Crash?
Market crashes and market corrections are often viewed as the same thing, but in reality, they’re very different, and that difference is important to understand when planning your moves. Market corrections are periods of downward movement of 10% or greater that happen over a series of days, weeks, months, or even longer.
Market crashes, on the other hand, are rapid, widespread declines in stock prices, marked by high volatility. While there is no official percentage decline that defines a crash, the declines are painful and dramatic — often 30% or more.
Market crashes generally take place when signs of a bear market are on the horizon, there’s a general feeling of overvaluation in equities, and economic conditions are questionable or in all-out financial crises. At these points, panic selling hits the market, and major indexes like the S&P 500 and the Dow Jones Industrial Average take dives.
Crashes were seen during the Great Depression and the bursting of the real estate bubble, but that’s in the general sense. Market crashes can also come out of nowhere, as was the case on Black Monday, October 19, 1987, when the U.S. market took the biggest single-day hit in history, and it happened out of nowhere.
What to Do if the Stock Market Crashes
While there’s no way to accurately time when the next stock market crash will be, there are some troubling warning signs for 2021 or 2022.
What should you do the next time Wall Street seems to go into an all-out panic? Follow the eight steps below:
1. Keep Your Cool
The first thing to remember when the floor falls out of the stock market is that it’s important to keep your cool. Emotion is the enemy of the investor, and emotional decisions can lead to significant losses far beyond what you should have to accept.
History tells us that market crashes are, for the most part, short-term movements that happen over the course of days, weeks, or months — or in severe crashes, maybe a year. Once the market reaches what investors perceive to be the bottom, stock prices begin to rebound, often leading to a long, drawn-out recovery filled with opportunity.
Some of the best examples of this are:
- COVID-19 Crash. The coronavirus pandemic led to sharp declines from February through March of 2020, but by the end of March, prices were already beginning to rebound. Investors who stayed the course enjoyed a swift, V-shaped recovery, and the S&P 500 began recording all-time highs again by August 2020.
- The Great Recession. The Great Recession was one of the worst market crashes in history. However, even during this drawn-out stock market crash, prices only declined for about six months, from August 2008 to March 2009. The bottom in 2009 was followed by the longest bull market in history, which spanned more than a decade.
- Black Monday. The Black Monday stock market crash led to the worst single-day losses in U.S. stock market history, but stock prices reached the bottom in less than a month.
The fact of the matter is that the market is known for upward and downward fluctuations, and some are better or worse than others. Seasoned long-term investors have learned to ignore these fluctuations because longer periods of bull market activity more than make up for the declines in the vast majority of cases.
That means a market crash isn’t a time to panic — it’s a time to think strategically.
2. Don’t Run From Opportunity
It may seem counterintuitive, but a market crash is one of the best times to find long-term opportunities in the market. Stock market declines will happen, but as the great value investor Warren Buffett would point out to you, it’s best to buy when the market is fearful and sell when the market is greedy. That’s the basis of Buffett’s favorite investment strategy, value investing.
There are tons of investment strategies to use during bear markets. Rather than turning and running from the market, pay close attention to what’s going on within it. When opportunity comes knocking, be ready to answer the door.
3. Assess Your Asset Allocation Strategy
One of the reasons long-term investors don’t fret about a market crash is because when they put their portfolios together, they do so following an asset allocation strategy based on their risk tolerance.
Asset allocation strategies outline how much of your investment portfolio should be invested in asset classes like stocks, mutual funds, index funds, and exchange-traded funds (ETFs) and how much of your portfolio value should be nested in safer assets like bonds and other fixed-income securities.
When the market is crashing, it’s the perfect time to assess your allocation strategy and determine whether it falls in line with your risk tolerance. If your portfolio isn’t quite as protected as you thought it was, it’s time to mix it up and bring more fixed-income investments into the picture. On the other hand, if your portfolio is too conservative, consider looking for opportunities to add undervalued stocks to your portfolio.
If you haven’t paid attention to asset allocation at all, it’s time to start. A great way to adjust your allocation for the first time is to use your age as a guide.
For example, if you’re 25 years old, consider investing 25% of your portfolio in low-risk fixed income securities and the remaining 75% in stocks and similar vehicles. As you age, more of your portfolio should be allocated to safer investments because you have more time to wait out and recover from declines should they happen when you’re younger.
4. Assess Your Diversification Strategy
You likely grew up hearing the old adage, “don’t put all your eggs in one basket.” This adage is an important one to remember in various aspects of life, including investing. In fact, diversification is key in any long-term investment portfolio.
To diversify means to spread your investing dollars over a variety of investment opportunities. That way if one or more investments falter, gains among other investments in your portfolio limit the impact of the blow.
When the stock market crashes, it’s a great time to assess whether your diversification strategy is working in your favor or against you. When looking at your portfolio, ask yourself the following questions:
Am I Investing Too Much Money Into a Single Asset?
Properly diversified portfolios have 20 or more separate investments, with no more than 5% in any single asset and no more than 5% total in the entire group of high-risk assets like penny stocks and Bitcoin.
If more than 5% of your asset value is invested in any single stock, it’s best to divest your holdings until the 5% cap is reached. You can use the money you gain from the divestment to invest in other opportunities.
Am I Investing Across Sectors?
Investors tend to invest in sectors they’re comfortable with. This is especially true for beginner investors.
However, if all of your investments are in the tech sector, and that sector crashes, you’ll be left with significant losses. A well diversified portfolio includes investments across various sectors, especially those that are not highly correlated with one another.
Am I Mixing In Safe Assets?
Growth stocks tend to be the biggest gainers in bull markets and the biggest losers in market crashes. On the other hand, income investments generate slow, steady growth and tend to hold their ground in bear markets.
Assess your portfolio to see whether your money is diversified between different styles of assets to protect you during rough times.
5. Look for Undervalued Opportunities
During a stock market crash, prices fall dramatically — that’s a given. But, as mentioned above, value investors like Warren Buffett will tell you that it’s best to buy when the market is fearful and sell when the market is greedy, and for good reason.
When buying during or shortly after a crash, you’ll enjoy lower prices than you would when the bulls are running on Wall Street. Considering that investing, at its core, is about buying low and selling high, a crash is the best time to buy, but it’s important not to go crazy and start buying everything you see.
Instead, make a calculated effort to find the stocks that are enjoying the largest undervaluations, as they will become the stocks with the biggest potential for gains when the crash is over.
Finding undervalued stocks is as simple as paying close attention to value metrics like the price-to-earnings (P/E) ratio or the price-to-book-value ratio.
Pro tip: Before you add any stocks to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Stock Rover can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.
6. Practice Dollar-Cost Averaging
Dollar-cost averaging is the process of spreading large investments out equally over a period of time. For example, if you wanted to buy $5,000 worth of ABC stock, you could decide to make five investments of $1,000 in ABC every day, week, or month.
Spacing out your investments following a crash protects you from sharp declines should the crash not yet be over.
Let’s say you decided to make five $1,000 weekly investments in ABC, which traded at $20 per share on week one, $15 per share on week two, $17.50 per share on week three, $20 per share on week four, and $15 per share on week five.
In this case, your $1,000 each week would purchase 50 shares, 66 shares, 57 shares, 50 shares, and 66 shares on weeks one through five, respectively. At the end of the five week run, you would end up with 289 shares of ABC stock.
If you had invested all $5,000 in ABC shares on the first week, you would have purchased 250 shares. By dollar-cost-averaging, you ended up with 39 additional shares for your money.
Looking at this example from a gain/loss perspective, either investment would have declined because ABC stock dropped from $20 per share at the beginning to $15 per share at the end. But the $5,000 one-time investment would be worth $3,750 at the end of the five-week period, while the separate investments would be worth $4,335, giving you less ground to make up when the market starts to rebound.
7. Rebalance When the Storm Passes
Volatility is commonplace during crashes. Wide fluctuations in value will ultimately throw your portfolio’s balance out of whack as some asset prices change more than others. Once prices start to rebound, it’s time to rebalance your portfolio and make sure it still aligns with your investment strategy.
Rebalancing a portfolio is a relatively simple process. Start by making a note of what percentage of your investment dollars are invested in stocks and similar assets and what percentage of your portfolio is invested in fixed-income investments. Doing so will let you know if your allocation is still in line.
Next, look at each individual investment and determine what percentage of your overall portfolio value is invested in each one. If those percentages are higher than you’d like them to be, divest the assets until your allocation has reached a comfortable level. Use the money you’ve divested from these investments to buy other assets that are underallocated according to your strategy.
8. Consider Hiring a Financial Advisor
Most people have a drive to do what they can for themselves, avoiding costs associated with hiring professionals. However, showing up to the stock market during a market crash without knowledge of the inner workings of the system or without a financial expert is like showing up to court without an attorney.
There’s no harm in seeking professional help when you’re not sure about something, especially when that something is your hard-earned money. If you’re still nervous about investing during a crash after reading this guide, it’s wise to seek the assistance of an expert. SmartAsset has a service that helps you locate fiduciary advisors in your area or you could use a service like Vanguard Personal Adviser Services.
Stock market crashes will happen from time to time; it’s the nature of the beast. However, by keeping your cool, adjusting your allocation and diversification strategies, and making wise decisions, these market declines can prove to be major opportunities.
As is always the case, whether the bulls or bears are running, it’s important to do your research and get a thorough understanding of what you’re investing in prior to making any investment decisions.