Stock Market Crash – How to prepare for the next bear market to minimize the impact on your portfolio

Learn how to protect your portfolio from a stock market crash and during a bear market scenario

The current bull market is now in its 10th year. We have no idea when it might end and give way to a bear market. However, it’s inevitable that at some point it will. Twice during 2018 we have already seen a spike in market volatility. This inevitably leads to fears of a market crash. The truth is that a stock market crash can never really be predicted. People who predicted crashes in the past are the same people who predicted crashes in the years they didn’t happen.

Bear Market Ahead / Negative Sentiment
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What you can do is prepare for the next crash. In fact, regardless of how the stock market is doing today, you should be prepared for a crash – because unexpected events (black swans) can trigger one at any time. You don’t need to wait for the next stock market crash prediction to come along to learn about bear markets, how they occur, why they occur, and what you can do to avoid being wiped out. We prepared this guide for that very reason.

What is a stock market crash?

Stock Market Crash / Newspaper Scrap
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There isn’t really a definition of a stock market crash. A correction occurs when stocks fall more than 10% from recent highs. A bear market is usually a sustained drop in prices, with prices falling at least 20% below recent highs. While there is no precise definition of a stock market crash, if the market falls more than 15% in a matter of days, many people would probably refer to it as a crash.

In May 2010 a “flash crash” occurred, with the market losing 9%, and then recovering most of those losses, all in the space of less than an hour. In terms of time frames, bear markets can go on for anywhere from 6 months to many years, while stock market crashes last anywhere from a day to a few months.

Some of the biggest stock market crashes in history

The following chart includes the four most famous market crashes in the last 100 years, all occurring on the Dow Jones Industrial Average. These four crashes indicate just how different one crash can be from the next.

DJIA Chart Big Crashes
Image Source: Tradingview.com / Dow Jones Industrial Average (log scale)

The biggest crash in history, known as Black Tuesday, began on Thursday October 24th, 1929. The worst day of the crash occurred the following Tuesday when the Dow Jones index fell 24% on the Monday and Tuesday alone, and then continued to fall for the next three years. The crash also led to the Great Depression which lasted for 12 years.

DJIA Chart - Stock Market Crash 1929
Image Source: Tradingview.com / Dow Jones Industrial Average (log scale)

While many smaller crashes occurred in the following five decades, the next famous crash occurred in October 1987. Notice how small the crash of 1987 was when compared to the crash of 1929. Yet, the crash of 1987 was a major event at the time. This was because the entire crash occurred over two days, while the crash of 1929 lasted years.

The crash of 1929 involved a total stock market collapse, whereas, during 1987 stocks remained in a bull trend despite the 23% decline. The bursting of the Dot Com bubble in 2000 doesn’t appear very pronounced on the above chart. However, remember it is a chart of the Dow Jones index, which only includes 30 blue-chip companies. If you look at the tech heavy Nasdaq for the same period, you will see a very different picture.

Nasdaq Chart Dot Com Bubble Crash
Image Source: Tradingview.com / Nasdaq Composite Index (log scale)

Between February 2000 and September 2002, the Nasdaq fell more than 75%, dropping from 4,696 to 1,172. Valuations were so high that despite the incredible performance we have seen from tech stocks like Apple, Amazon and Google since 2002, the Nasdaq only regained its previous all-time high in 2015.

The second biggest crash in global markets occurred in 2008. It was preceded by a housing market crash which led two Wall Street banks, Bear Stearns and Lehman Brothers declaring bankruptcy. By 2008 the world economy was so interconnected that the market crash led to a global financial crisis. Although it wasn’t the largest crash in percentage terms, it was the largest drop in terms of value in the history of the New York Stock Exchange.

Financial Crisis
Image Source: Jakub Krechowicz / Shutterstock.com

The equity market actually peaked in late 2007, and appeared to be undergoing a correction in early 2008. However, after a brief recovery in April 2008 failed to reach the all-time highs, the market fell for the following 11 months. By March 2009 the S&P 500 index had fallen more than 55%. Unprecedented action by the Federal Reserve to stimulate the economy and market led to the beginning of the bull market that has continued until today.

When studying bear market history, emphasis is often placed on the percentage losses suffered by major indices like the S&P 500 and DJIA. However, just as important is the time it takes for these indices to recover their losses. The 1929 crash saw the Dow Jones index fall nearly 90%, but more importantly, it took 30 years to recover those losses.

Nikkei 225 Chart Crash 1989
Image Source: Tradingview.com / Nikkei 225 Index (log scale)

In the history of global markets, the 1929 to 1959 period in US market history wasn’t a one-off event either. In December 1989, Japan’s Nikkei 225 peaked at 38,900. 29 years later it is still 40% below that high, after bottoming in 2009, 81% below the all-time high.

How much have stocks declined during previous market crashes?

DJIA History 1896-2016
Image Source: MarketWatch

The bear markets mentioned so far are some of the worst in history, but most are far less severe. Since World War II, there have been about 15 bear markets in US stocks. On average, those bear markets have seen stocks decline by 26%. Three of the 15 crashes saw markets fall more than 40%, and another three saw markets decline 30 to 40%.

What events can cause a stock market crash?

Economy / Economic Factors
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Stock market crashes are usually caused by more than one factor. In fact, there are often two sets of reasons for a crash. One set of conditions creates the environment for the sell-off, and another set of factors triggers the beginning of the sell-off. Just because there is a market bubble, it doesn’t mean the market will crash. Usually something needs to occur to cause investors to begin selling and buyers to step away from the stock market.

High valuations, falling or disappointing corporate earnings, bankruptcies, falling consumer spending, rising inflation, a recession or stagnant economic growth, and geopolitical events can all create the environment for a correction, a crash or a bear market. The beginning of a sell-off is usually triggered by falling liquidity.

Falling liquidity may occur if banks stop extending credit or if a regulator increases the margin requirements for traders. Sometimes when a central bank raises interest rates, banks will begin to call in some of their loans, triggering a shortage of liquidity in the market. The simplest explanation is that at some point the money runs out. Markets rise while investors continue to buy, and when they run out of money, markets fall. The exact cause of a crash is often easy to see in hindsight, but difficult to see at the time.

When will the next stock market crash happen?

Financial Crisis / Pocket Watch
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So, when will the stock market crash again? There is no way to accurately predict a bear market. The FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) have led the bull market over the last 9 years. If these stocks fail to keep their earnings momentum going, investors may lose confidence in the market. So far only Facebook and Netflix have disappointed investors, while Apple remains as strong as ever.

The CAPE ratio (also known as Shiller P/E ratio) is a long term cyclically adjusted measure of equity valuations devised by the respected economist Robert Shiller. The CAPE ratio has been at historically high level for several years, although high valuations alone do not mean a crash is imminent. Whether US stock prices today are in a stock bubble or not is debatable. In general, bubbles do not necessarily imply a crash, unless there is a catalyst.

Trade War USA vs. China
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An escalation of the trade war with China and Europe could eventually lead to earnings momentum falling. Unsustainable levels of debt in China and other emerging markets could also trigger a crash. If China’s stock market were to crash, that alone probably would not trigger a bear market around the world.

However, if China’s economy falters it might. Geopolitical turmoil concerning North Korea, Iran, Syria or Russia could also become a catalyst if things escalate enough. It’s most likely that the next market crash, whenever it occurs, will be the result of a perfect storm caused by several factors. But, since it’s not something anyone can predict, it’s best to concentrate on being prepared for a crash whenever it may occur.

How to prepare for the next stock market crash

Investor / Bull & Bear
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Being prepared for a stock market crash is as much about attitude as anything else. For starters and beginner investors it’s worth remembering the following:

  • In the long run investors are rewarded for taking on risk. Avoiding risk entirely, means avoiding returns. Numerous experts have predicted a 50% crash every year since 2009. If you had followed their advice, you could have missed out on over 200% of gains to avoid a 50% crash that never happened.
  • The world’s most famous investors have managed to generate returns over the long run despite numerous market crashes. They have up-years and they have down-years, but over the long run the up-years add up to far more than the down-years.
  • There is no single solution that will protect your assets from every bear market. Every crash is different and sometimes safe-havens don’t turn out to be as safe as they were supposed to be.
  • Inevitably some of the investment decisions you make will turn out to be wrong. Therefore, diversify your portfolio and don’t let one decision put you at risk of being wiped out.
Trader / Buy / Sell
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In other words, bear markets are part of investing. You can’t avoid them – but you can make sure a bear market doesn’t wipe you out. Rule number one is to diversify, and periodically rebalance your portfolio. When a correction, stock market crash or bear market comes along, the stocks that fall the most are those that are trading at the highest valuations, those with the most debt, and those with the lowest margins.

These stocks are known as high beta stocks, as they outperform on the way up and underperform on the way down. During a bull market, these high beta stocks are often the stocks that perform best. As a result they will grow into the largest positions in your portfolio. That’s why it’s a good idea to rebalance your portfolio and make sure the weighting of these “high beta” stocks aren’t too high. Here some more ways to prepare for a stock market crash:

Shift to defensive asset classes and safe haven investments

Investment / Asset Classes
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To reduce losses during a bear market, you can spread part of your portfolio across the following stock market sectors and other asset classes that are considered defensive:

Defensive stocks

Non-cyclical consumer stocks and utilities trade at lower valuations, and usually continue to generate profits during recessions. These are the companies that sell goods and services that are consumed regardless of the economic cycle – pharmaceuticals, cleaning products, groceries and gas are good examples.

High quality dividend stocks and blue-chip stocks

Dividend Payment Analysis
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Solid yet boring companies are often overlooked and ignored during bull markets when investors focus on growth stocks. When stocks begin to slide, a flight to quality will often occur, causing these stocks to outperform. It really boils down to owning the stocks that will survive a recession.

Precious metals

999.9 Fine Gold
Image Source: Global_Intergold – Pixabay.com / License: CC0 Public Domain

Precious metals like silver and gold are widely considered as safe haven assets, and have historically outperformed during most (but not all) market crashes. You can buy precious metal ETFs, physical metal, or you can buy shares in precious metal producers and mining companies.

Bonds

United States Treasury Savings Bonds
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Historically, bonds have outperformed stocks during almost every stock market crash and bear market. However, with bond yields at historical lows, they do carry more risk now than they have in the past. They are worth consideration, just be careful of having too much exposure to bonds.

Hedge funds

Hedge Funds
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Hedge funds are an alternative for investors with large enough portfolios. Hedge funds use a combination of long and short positions, and other strategies to generate returns regardless of the direction of the overall market. However, when considering hedge funds, you should tread with caution and do your own research. Some hedge funds have performed very well, especially during bear markets – but many others have performed very poorly. Just because a hedge fund is called a hedge fund it does not mean it will perform well during a crash.

Cryptocurrencies

Bitcoin / Cryptocurrency Chart
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Although we’ve seen more recognition of cryptocurrencies as investment vehicle, they’re still considered high-risk investments. Some see Bitcoin as safe-haven in case of a global crash due to its decentralized nature, the low correlation with the stock markets and the limited supply. Though, there is no reliable data available on how cryptocurrencies behave during a stock market crash. However, if you’re willing to take the risk, adding a small percentage of Bitcoin or cryptocurrency stocks to a diversified portfolio could be a worthwhile investment decision.

Use stop loss orders to make rational decisions

Stop Loss / Panic Button
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If you are concerned about how much you could lose on some of your largest positions, you can also think about using stop loss orders to mitigate potential losses. For each stock, you can set a few price levels below technical support where you will begin to reduce the size of the position. It’s best to do this long before stock prices begin to fall so that your decisions are rational and not driven by emotions. Stop losses are not generally a strategy used by long term investors. However, they can help you manage the emotional pain of a bear market.

Hold enough cash to benefit from a stock market crash

Currency Trading
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Perhaps the best way to hedge your portfolio against a crash, is to make sure you always have a healthy portion of it allocated to cash. The amount you allocate to cash really depends on how much volatility you are happy to tolerate. More cash means you stand to lose less, but you will probably lose out on returns in the long run. A lower cash balance will probably lead to higher overall returns, but will also mean higher volatility.

The other advantage of holding cash, especially after a prolonged bull market, is that you will be able to buy cheap stock when a crash does occur. Remember, after a crash, the risk is much lower – that’s when you want to allocate more to stocks, and less to defensive assets, precious metals, bonds and cash.

Conclusion: Prepare for the next stock market crash

Charts Trending Downwards
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As you can see, there is more to preparing for a market crash than making a stock market crash prediction. “Experts” predict crashes all the time, and most of the time they get it wrong. If you listen to all these crash predictions, you will end up losing out on the upside. And yet, you should never be in a position where a crash will wipe out your portfolio or brokerage account. To prepare for a crash, you should make sure your portfolio is diversified, and that you don’t have too much of it allocated to high beta and growth stocks.

You can cushion the effects of a crash by allocating to defensive and blue-chip stocks, bonds, gold and cash. Having some cash in your portfolio also allows you to buy back into the market at lower levels. The current stock market is fairly expensive, but there are no signs of an imminent crash. However, that doesn’t mean market conditions can’t change quickly. That’s why you should always be ready for the next crash.

What are your thoughts on the stock market? When do you think the markets will crash? And most importantly, how do you prepare for the next bear market? Please share your thoughts and feedback in the comments below.

About Richard Bowman
Richard Bowman is a writer, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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