Estimated reading time: 8 minutes.
Worried about the next market crash? This article gives you practical steps to protect your investments. You'll learn how to avoid permanent losses by managing your portfolio wisely, like increasing cash holdings and using trailing stop-losses. The article also explains why timing the market is nearly impossible, and how moving to cash can give you a psychological and financial edge. It’s all about staying prepared so you can sleep soundly and seize opportunities when the market dips.
Perhaps you, like a friend, is worried about a market crash.
His portfolio was up way up and markets were roaring higher. Not just the stocks he owned but everything.
Like you he was worried about a crash for good reasons:
- He wanted to protect his gains
- He was wondering how long this can go on
- He saw the US markets, already overvalued by every valuation ratio you choose to look at, hitting new highs every day
- The overvaluation and new all-time highs seem to be popping up everywhere
How to prepare for a crash
We talked at length on what to do.
We agreed his greatest risk and worry was a permanent loss of capital. Perhaps something that is also on your mind.
How to avoid permanent loss of capital?
Just what is “permanent loss of capital” and how can I avoid it you may be thinking.
A permanent loss of capital happens if any asset you hold falls in price and does not recover. It can also happen if an asset falls in price, and you sell before it can recover.
Permanent loss of speculative assets
Examples are speculative assets with no underlying value.
Think, tulip bulbs, crypto currencies, beanie babies, or loss-making start-ups (with no hope of a profit). Because none of these things (we cannot really call them assets) have an underlying value their price is determined by the last buyer.
And a higher price depends on a buyer willing paying more in future.
Permanent loss of an overvalued asset
Permanent loss of capital can also happen when you hold an overvalued asset.
For example, assume that a fair value for a growing large quality company is a price to earnings ratio (PE) of 20 and for a similar small company a PE of 12.
Here are the PE ratios of the largest US tech companies:
- Meta (Facebook) 32
- Apple 28
- NVIDIA 65
- Alphabet 24
- Amazon 60
- Microsoft 37
- Tesla 41
The average PE of the above companies is 41. For these companies to trade at a PE of 20 from a PE of 42 they must fall 51% in price.
Even if you think a 25 PE is fair their prices must still fall 39%!
This is already bad, BUT remember they are not going to trade up to the PE of 41 that they reached before they crashed. They will most likely trade at 20 to 25 times earnings.
This means this loss is a permanent loss of capital.
Compare this to undervalued companies
Compare this to an undervalued company portfolio – the kind of companies you invest in with the Quant Value newsletter. The current PE of the newsletter’s portfolio is 9.7.
Or the companies in the large cap strategy newsletter with a high Shareholder Yield, they have a PE ratio of 15.8
If you assume a fair PE is for small companies is 12 and large companies 20, it means the Newsletter’s portfolios are trading below fair value. (They are more undervalued, but I do not want to get into that here.)
This means if the market crashes the Newsletter’s portfolio will also decline, but when dust settles, and things return to normal, and these companies will trade at about their current value.
Thus, no permanent loss of capital.
The best way to hedge the risk of a market crash
After a LOT of research and calculations I found that there is no cost effective way to actively hedge against a market crash or bear market.
The problem with hedges is they depend on you getting the timing right which is VERY hard to do!
Taxes also don't help because you must pay taxes on your hedges when you sell them (they go up in value), but you have unrealised losses on your stocks that you may not want to sell.
Hedging is also expensive. For example, a strategy that holds put options on the S&P 500 costs over 7% per year. If you hedge for two years your hedging ALONE will be over 14%.
Simply move to cash
The simplest and best way to hedge a market crash is to increase the cash part of your portfolio.
For example, if you sold 30% of your portfolio you reduce your losses by 30%. If your portfolio is €100,000 and you sold €30,000 this means when the market falls 30% your loss will be 21% or €21,000 and not €30,000.
This is not rocket science you may be thinking, and you are right.
This gives you three big advantages
BUT you have three big advantages when you sold 30% of your portfolio:
- You do not have the psychological loss. A 21% loss is less painful than 30%. This means you will be less risk averse and will have the courage to buy stocks again.
- You will be less likely to sell in panic because of the lower loss. This will keep you invested so that you can recover from the loss. Remember if you sell you have no way to recover a loss.
- You have €30,000 in cash to invest into a lower and cheaper stock market. AND you do not have to sell stocks at a loss to get this cash. This is a big psychological advantage, as you know realising losses is hard to do because they hurt emotionally.
What to sell
What should you sell first you may be thinking?
You may want to start by selling investment already in a loss and stocks underperforming the market. Stocks with bad momentum in other words.
Also think about selling about half of companies that have increased more than 50% in value since you bought them.
Do this until 30% of your portfolio is in cash.
What to do with the rest of your portfolio
With the rest of your portfolio, we recommend you follow rules to keep losses low, the same rules we follow with the Quant Value and Shareholder Yield investment newsletters.
Implement a trailing stop-loss strategy
The first thing to do is implement a strict stop-loss strategy in your portfolio. This is how you do it:
- Implement a trailing stop-loss strategy where you calculate the losses from the maximum price the company reached since you bought it
- Only look if the stop-loss percentage has been exceeded on a monthly basis. If you look at it daily, you will trade too much and the costs will lower your returns. If you think markets are expensive look at your stop loss more often, weekly or even daily. Select what you are comfortable with.
- Sell your investment when the trailing stop-loss level of 15% or 20% has been exceeded
- Measure the trailing stop-loss in the currency of the company’s primary listing. This means measure the stop-loss of a Swiss company in Swiss Francs (CHF) even if your portfolio currency is Euros or US Dollars
- See rule below, else reinvest the cash from the sale in the best idea that currently fits with your investment strategy. If you subscribe to the newsletter you would invest in the ideas you receive with the next newsletter
Stop buying when markets are falling
You know when markets fall, they all fall together – in more technical terms – they become correlated. This means, when markets are falling and you keep on buying, these investments will soon be sold because of the trailing stop loss system mentioned above.
This is definitely not what you want!
To solve this problem, we follow a simple rule (based on a LOT of solid research) - No new ideas are recommended when the markets are falling.
This means we will only recommend new ideas if the moving average of the respective market index is above its 200-day simple moving average (SMA).
This is how it works:
- If the S&P500 index is above its 200-day SMA (and we can find good, undervalued companies) we will recommend investment ideas in North America.
- If the S&P500 index is below its 200-day moving average no North American companies will be recommended because it means the market is falling.
Summary and Conclusion
So, what did my friend do?
He sold his whole portfolio to give him the freedom to think from an uninvested point of view. The portfolio was in a tax-free account which helped the decision. He then increased his margin of safety (looked for cheaper stocks) and slowly started buying again.
Here is how you can you best prepare for a market crash:
- Know that you and I will NEVER get the timing right, so prepare in advance
- Sell as much of your portfolio so that you feel comfortable
- Know that you will regret your decision to sell if the market goes higher
- Make sure that you cash is safe. Buy US T-Bills or similar low risk cash assets to make sure your cash safe irrespective of what happens to you bank or broker
- Change the cash percentage as the markets go even higher and get even more over-valued. Again, so that you are comfortable and can sleep well. There is no right answer here.
When will you start investing again?
To help you start investing again after a crash we suggest you prepare a list of companies you want to buy once the market falls. You can take a look at the criteria we use for the newsletter's market crash portfolios.
Decide if you want to implement a trailing stop loss, and a rule to not buy if markets are falling, i.e. below their 200-day simple moving average as described above.
Prepare a strategy of how and when you will start investing again. For example buy 10% of your portfolio after a 25% market fall.
This is important so that you do not become paralysed.
This happened to me during the last two market crashes. I now have rules that at after a 20% fall I invest 10% in half positions. At a 30% fall I buy full positions for another 10% of my portfolio.
Frequently Asked Questions
1. How can I protect my investments from a market crash?
Consider selling a portion of your portfolio to increase your cash reserves. This reduces potential losses and provides funds to buy when prices are low.
2. What should I sell first during a market downturn?
Start by selling stocks that are already underperforming or have increased significantly in value. This helps you lock in gains and cut losses.
3. Is it wise to move all my investments to cash?
Not necessarily. Moving a portion to cash is smart, but keeping some investments allows for growth potential when the market recovers.
4. Should I use stop-loss orders to limit losses?
Yes, implementing a trailing stop-loss strategy can help you protect your investments by automatically selling when losses exceed a set percentage.
5. What’s the best way to time the market?
Timing the market is extremely difficult. Instead, focus on preparing in advance by adjusting your portfolio to a level where you’re comfortable with potential losses.
6. Is it possible to hedge against a market crash effectively?
Hedging can be expensive and complex. A simpler approach is to increase your cash holdings, which also gives you the flexibility to buy during a downturn.
7. How can I avoid a permanent loss of capital?
Avoid holding overvalued or speculative assets, as these are more likely to suffer irreversible losses during a market crash.
8. When should I start buying again after a crash?
Create a plan in advance. For example, consider buying in increments as the market drops, starting when it falls by 20-30%.
9. What types of companies should I buy during a market crash?
Focus on undervalued companies with strong fundamentals. These are more likely to recover and provide long-term growth.
10. How can I keep calm during a market downturn?
Reducing your exposure to risk by selling some assets and increasing cash can reduce anxiety. Having a plan in place also helps maintain confidence.
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