With volatility returning to the markets, many people are asking how to survive a market crash.
The U.S. stock market has been on a remarkable run.
Over the last five years (as of this writing on February 6, 2018), the Russell 3000 index (made up of the largest 3000 U.S. stocks) had an average annual return of 15.58%.
In 2017, international developed market stocks (as measured by the FTSE all share index) gained upwards of 27%, with MSCI emerging market index rising over 37%.
Though there were some exceptions, 2017 was a remarkably calm year for the markets.
It is normal for markets to fluctuate, sometimes dramatically.
In light of this activity, I want to offer some tools to help you get through volatile markets.
Avoid making emotional decisions
That usually happens in times like the past few years when markets seem to keep going up.
It happened in dramatic fashion in 2000 when the “dot com” stocks rose to levels that made no sense.
It happened again in 2008, just before the financial crisis hit and the S & P 500 dropped over 37%.
Most of the stock buying frenzy comes out of FOMO. Fear of missing out often causes people to make very bad decisions.
Normally cautious, conservative investors hear the constant media drumbeat of how the market continues to go up.
They hear it from their neighbors, friends, and coworkers. Eventually, FOMO kicks in and pushes them to invest.
John Maynard Keynes gets credit for saying, “the markets can stay irrational a lot longer than you can stay solvent.”
Keep this in mind when thinking about investing. It could help you avoid making investment decisions you will regret.
Invest with a market crash in mind
If you're working with an advisor, chances are they will promote how much the funds they recommend have made over the years. Often, they show those numbers as average annual returns.
Average annual returns don't represent a potential worst-case scenario.
Look at how the portfolio would have performed in the 2008/early 2009 market environment. Would it have been down 10%? 20%? 3o%?
Whatever the number is, ask yourself how that would make you feel.
Though percentages are helpful, the real measuring method that matters is the amount of paper loss of money that percentage represents.
Let's say you have a $500,000 portfolio that drops by 10%. Of course, that means your $500,000 portfolio is now worth $450,000. A 20% drop makes it worth $400,000, and so on.
Looking at real dollars puts things in a different perspective than a percentage. It shows the real money involved.
Any drop in portfolio value needs to pass the stomach test.
What does that mean?
If, when you look at the drop in dollar value of your portfolio you get a queasy feeling in your stomach, you've failed the stomach test.
You're probably taking too much risk. If you feel queasy or panicky during these times (or thinking about these times) it often leads to irrational, costly emotional decisions.
Do yourself a favor – TAKE THIS TEST to see if you have the right investment mix.
Stick to your investment strategy
Times of heightened market volatility can cause you to question your investment strategy. If you do, be very careful.
In the 2008 financial crisis, many investors allowed fear to guide their investment decisions. They didn't follow Warren Buffet's advice and sold their stock holdings at the worst possible time.
During that period, Mr. Buffet was buying huge amounts of companies that had fallen on hard times during the financial crisis. When other people were selling, Mr. Buffet was buying.
This article, written in 2013 says that Warren Buffet made over $10 billion from investments he made during the financial crisis. Imagine what those investments are worth today!
Mr. Buffet follows the age-old investment wisdom of buying low and selling high. If you're selling when the market is falling, you're doing just the opposite.
If your stomach gets queasy during times of market volatility, you're portfolio probably has more risk than it should.
The worst thing you can do is to sell stocks when the market is dropping. When your stock holdings (whether individual stocks or mutual funds) are dropping, consider buying more of them.
If it's good enough for Warren Buffet, it should work for you as well.
When you're investing in individual stocks, make sure they are good quality business.
If you invest in bad businesses just because the market is down, You're still investing in bad businesses.
For most people, broadly diversified, low-cost index funds are the best choice.
Even Warren Buffet recommends index funds for most investors.
If market drops put you into a panic, you probably shouldn't own stocks. At the very least, you should consider reducing your risk.
Volatility is part of what comes with investing in the markets.
The worst strategy you can have is to follow the crowd.
Don't sell because everyone else is selling. Conversely, don't buy when everyone else is buying. The herd is seldom right.
Invest in the markets for the long-term. Taking actions based on short-term market activities rarely turns out well.
Stick to your investment strategy. Have the courage to buy when everyone else is selling, with the caution of only investing in great companies or funds that own great companies.
Trust what the evidence says about the long-term investment returns the markets offer. Turn off the financial news. Ignore the doomsday headlines.
Now it's your turn. Have you put your portfolio through a stress test? Does it pass the stomach test? Have you prepared for a worse case scenario? Let me know in the comments.
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