Market crashes are inevitable, and it's normal to worry about them.
You, like many investors, might feel anxious when the market is soaring because you know it can't last forever. Like me, you're probably concerned about protecting your gains and wondering how long the current highs can continue.
This worry is valid, especially when markets are hitting new highs every day and seem overvalued by all traditional measures.
Let's explore how to prepare for and manage the impact of a market crash on your portfolio.
Understanding Market Crashes
A market crash is a sudden and significant drop in stock prices, often caused by economic factors, geopolitical events, or widespread panic. Historically, crashes like those in 1929, 1987, and 2008 have shown how devastating they can be for investors.
These events not only affect your financial stability but also take a toll on your mental well-being. That is why it's crucial to understand that crashes happen, and being prepared is the best defence.
The Role of Stop-Loss Orders
You can use stop-loss orders to protect your investments from severe losses. A stop-loss order is an instruction to sell a stock when it reaches a certain price, thus limiting your loss on a falling stock.
There are different types of stop-loss orders: standard (calculated from your buy price) and trailing stop (stop loss price is adjusted higher).
Each type has its advantages and disadvantages, but the key benefit is that they help you manage risk automatically without needing to monitor your investments constantly.
We recommend that you use trailing stop losses. You can read more here:
Truths about stop-losses nobody wants to believe
How to calculate your trailing stop loss correctly
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Historical Data Analysis
Looking at past market crashes, stop-loss orders could have significantly reduced losses.
For example, during the 2008 financial crisis, if you had set stop-loss orders at 20% below the peak prices, you would have avoided deeper losses as stocks plummeted by over 50%. Similarly, during the Dot-Com Bubble, stop-loss orders could have protected your investments from massive declines.
Why It Is Important to Keep Losses Low
Keeping your losses low is important because it requires a much higher percentage gain to get back to your original value.
Also, large losses are also emotionally draining, and this often leads to poor decision-making.
Let’s look at some examples:
- 10% Loss: If your investment falls by 10%, you need an 11.1% gain to recover.
- 20% Loss: A 20% drop requires a 25% gain to break even.
- 30% Loss: For a 30% loss, you need a 42.9% gain to get back to where you started.
- 40% Loss: A 40% decline means you must achieve a 66.7% gain to recover.
- 50% Loss: The most daunting, a 50% loss requires a 100% gain to return to your initial investment value.
And it only gets worse at losses over 50%.
You can see that the gains needed to recover grow exponentially. This mathematical reality is why it's essential to keep losses low.
Emotional Stress and Bad Decisions
Beyond the numbers, large losses cause significant emotional stress. When you see a substantial portion of your investment disappear, it's natural to feel panic and despair.
As if that is not bad enough, emotional stress can lead you to sell at the worst possible time, locking in your losses with no way to recover.
In a spreadsheet, a lot of investors think they can easily handle a 30% loss. The reality however is that many sell out completely at the market's lowest points and abandon investing altogether. This not only locks in their losses but also prevents them from benefiting from future market recoveries.
For example, during the 2008 financial crisis, many investors panicked and sold their stocks at rock-bottom prices. When the market eventually recovered, those who stayed invested saw substantial gains, while those who sold out missed the recovery.
This cycle of buying high out of excitement and selling low out of fear can be devastating to your long-term financial health. It is something you want to avoid at ALL costs!
We will show you how to keep losses low but before we do look at this table, it will help visualize how different loss percentages require increasingly larger gains to recover:
This table clearly illustrates the importance of keeping losses low. Not only for your financial but also emotional stability.
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How to Keep Your Losses Low
Implementing Stop-Loss Orders in Your Investment Strategy
To set up stop-loss orders, first, decide on the percentage loss you're willing to lose, 15-20% have been shown to work best.
As mentioned, we recommend that you use a trailing stop-loss, which adjusts with the stock price movement, to maximize your protection and lock in gains.
Never Leave Your Stop Loss Order With Your Broker
We recommend that you NEVER leave a stop loss order with your broker (entered into your broker's platform) but rather calculate your stop loss orders yourself in a spreadsheet or use an automatic stop loss alert service.
This is because normal market volatility, or a flash crash may trigger your order even thought the closing price may not have changed at all.
Recovery Plans After a Market Crash
When a market crash happens, it's important to have a recovery plan.
Start by evaluating your portfolio. What do you want to hold and what do you want to sell to buy other more attractive investments?
Always think of the long term and avoid panic selling. Remember, markets recover over time. Having a solid plan helps you stay disciplined and focused on long-term goals rather than short-term losses.
Practical Crash Recovery Strategy
A practical idea to help you start investing again is to prepare a list of companies you want to buy once the market falls or has fallen.
You can look at the criteria we use for the newsletter's market crash portfolios here:
Quant Value Crash portfolio rules
This preparation ensures that you are ready to act when prices drop.
Next, decide if you want to implement a trailing stop loss and establish a rule not to buy if markets are falling, such as when they are below their 200-day simple moving average. This disciplined approach helps you avoid buying during continued downturns, which can further protect your investments.
Have a clear strategy for when and how you will start investing again. For example, you might decide to buy 10% of your portfolio after a 25% market fall. This methodical approach can help you avoid paralysis by analysis, where fear can prevent you from acting.
This approach is based on personal experience. During the last two market crashes, I found myself paralysed and unable to make decisions.
- Now, I have specific rules: after a 20% market fall, I invest 10% in half positions.
- If the market falls 30%, I buy full positions for another 10% of my portfolio.
These rules ensure that I stay active and invested, taking advantage of lower prices without being overwhelmed by fear.
By planning your recovery strategy in advance, you not only protect your investments but also maintain the emotional resilience needed to navigate market volatility. This helps you remain a confident and disciplined investor, ready to capitalise on opportunities even in the face of market downturns.
Balancing Technical and Psychological Aspects
Investing isn't just about the numbers, it's also about managing your emotions.
- Use technical tools like stop-loss orders and data analysis to make informed decisions. At the same time, work on building your psychological resilience.
- Stay calm during market volatility and stick to your investment strategy.
- Avoid making impulsive decisions based on fear or greed.
- Keeping a balanced approach will make sure you don't overreact to market fluctuations and stay focused on your long-term investment goals.
Practical Insights and Actionable Advice
To protect your portfolio from crashes, start by increasing the cash portion of your investments when stocks may still be moving up, but you start feeling like valuations have become too high.
There is no right time to aim for here, no one knows when markets will turn around.
Look at possibly selling 30% of your portfolio to significantly reduce your potential losses. For example, if your portfolio is worth $100,000, selling for $30,000 means your loss in a 30% market drop would be $21,000 instead of $30,000. This approach gives you the psychological advantage of smaller losses and the financial advantage of having cash ready to invest when the market is low.
Summary and Conclusion
In summary, preparing for a market crash involves using stop-loss orders, maintaining a balanced portfolio, and having a recovery plan.
Selling a portion of your portfolio and increasing your cash holdings (even if you are early) can help you weather the storm.
It is all about tools to help you stay calm, avoid panic selling, and focus on your long-term investment goals. By implementing these strategies, you can protect your investments and be ready to take advantage of opportunities when the market recovers.
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