In early 2020, the global stock market began to head into bear market territory as the coronavirus pandemic began to set in. Market downturns are always a shock, but this particular downturn was even more so because it followed the longest bull market in U.S. history. The last time stocks had experienced such significant downward volatility was in 2008 during a financial crisis later dubbed the Great Recession.
The U.S. Federal Reserve quickly responded by slashing interest rates and spurring economic growth through quantitative easing.
Between the Fed’s monetary policy changes and stimulus checks, the economy and market began to mirror the Roaring ‘20s. Nothing seemed impossible in the market. But those moves started to backfire in 2022. Excess demand produced the highest levels of inflation the country has seen in decades. As the Fed worked to taper it, the market took a dive and the S&P 500 had fallen more than 20% by mid-June.
How should investors respond in the face of a market crash?
What to Do When the Stock Market Crashes
Market downturns are scary events. It’s hard to watch your IRA shrink as you hear financial media talking heads play out best- and worst-case scenarios, with neither sounding much better than the other.
The first thing you should do is relax.
This isn’t the first time the stock market has crashed, and it won’t be the last. According to Covenant Wealth Advisors, the S&P 500 has fallen more than 20% 12 times since 1950.
That means that over the past 72 years, there has been a significant drawdown in the U.S. market every six years on average. Every time it happens, the market recovers, and people eventually move on with their normal lives.
But what should you do in the meantime? Here are some tips for actions you should take when the stock market crashes.
1. Stick to Your Investing Strategy
A solid investment strategy isn’t just designed for you to use during bull markets; it’s designed to protect you as the bears take hold as well. You shouldn’t have to abandon your strategy when stock prices start to fall.
Instead, continue to follow your strategy and let the protections built into it go to work.
However, you may want to make minor adjustments to your asset allocation strategy. That’s especially the case if you have a cyclical stock portfolio. Consider taking a more bearish stance by increasing your safe-haven allocation and adjusting your stock allocation toward a heavy dose of non-cyclical stocks like health care and utilities.
2. Don’t Panic Sell
Panic selling is the first reaction many have to market downturns — especially beginner investors. Experienced long-term investors know that panicking isn’t the answer.
Sure, you may want to selectively sell some stocks, but you don’t want to go to your brokerage and cash out your portfolio. Instead, it’s time to analyze your performance and make educated decisions to adjust your holdings as market fluctuations bring out the best and the worst in investment opportunities.
Follow these steps to get started:
- Analyze Performance Since the Downturn. Make a spreadsheet list of the stocks you own ordered by the percentage gain they’ve experienced since the market started to fall. The stocks at the top of the list are your best performers during a bear market, but that doesn’t mean you should sell the stocks at the bottom of the list yet.
- Analyze the Overall Performance of Each Holding. Consider the price you bought each stock for in comparison to its value today. You may find that some stocks in your portfolio performed so well in the bull market that it’s worth holding them when the bears come out to play. In other cases, you may have held a stock for a few years and all its gains were wiped out in the first couple of months of a bear market.
- Sell the Duds. Now, it’s time to strategically sell. Start by selling the stocks that have produced losses. Add up the losses as you do. Next, look at your underperformers that are still in the green. You want to sell some of these, but you want to limit the profits you take to the exact amount of your losses. This process is called tax-loss harvesting (more on this later). This strategy uses the losses in some investments to offset the capital gains taxes you would normally pay on gains in others.
- Reallocate Unused Funds. Considering your investment strategy, reallocate the money you freed up through the sales. Buy more shares of your best performers. Also, consider buying shares of stocks that are down but performed so well in bull markets they were worth holding; that’s where you find the best discounts.
3. Think Long Term
Market corrections and crashes are nothing new. They happen so regularly that some seasoned long-term investors don’t even pay any attention to their short-term effects. There are good and bad days no matter what long-term investment you make. When you make rash decisions on short-term trends, you usually make mistakes.
There are a few things that are hard to remember when markets are falling, but they’ll put your mind at ease:
- Market Crashes Are a Regular Occurrence. Market crashes happen about every six years on average. Every time they happen, the market goes into a Chicken Little-worthy “the sky is falling” panic. Well, my friends, the sky hasn’t fallen yet.
- Market Crashes Are Short Term. The average market crash lasts for about 342 days. That seems like a long time, but it’s a drop in the bucket in the grand scheme of things. If every crash were exactly six years apart and lasted 342 days, there would be about 1,849 days of bull market activity between each crash. However, it’s important to note that these are averages; the market crash of 2020 only lasted about a month.
- What Goes Down Must Come Up. There has been a significant rebound in stock prices after every market crash in history. Therefore, market crashes have historically presented opportunities to load up on the best performers at discounted prices and enjoy riding the wave back to the top.
4. Rebalance Your Portfolio
When you built your investment portfolio you kept a healthy balance in mind. You carefully considered your risk tolerance and chose your asset allocation to match. Some assets grow faster than others, and in a market crash, some fall faster than others.
Chances are, your portfolio isn’t nearly as balanced after a crash as it was when you started investing.
As you rebalance your portfolio, reassess your risk tolerance. Given the current condition of the market, chances are you’re not feeling as aggressive as you once were. If you’re not sure where you stand in terms of risk tolerance or where you’re comfortable with asset allocation, you can use your age as a guide.
For example, if you’re 35 years old, consider investing 35% of your portfolio assets in fixed-income securities, leaving 65% of your assets in stocks. Of course, this is just a rule of thumb based on a moderate risk tolerance. If you want a more conservative portfolio while the storm blows over, consider adding more bond allocation. If you’d rather take the aggressive approach as you ride out the storm, consider a larger stock allocation.
5. Consider Tax-Loss Harvesting
Tax-loss harvesting is a strategy you can use to reduce the overall tax burden on your investments. You only pay taxes on net gains from your investments. That means you can use your losses to offset your gains — and a market crash is a great time to do it.
If you’ve cashed in profits at any point this year, consider selling some of your assets that are currently experiencing losses to offset those profits. Keep in mind that losses offset profits on a one-to-one basis. If you’ve earned $500 in the market, you’ll need to realize $500 in losses to offset the tax burden of your profits.
It’s also important not to sell a stock just because it’s producing losses. For example, if you purchased a stock three months ago and the market crashed one month ago, that stock didn’t have much time to grow to profitability before the declines. However, it may be falling slower than other assets in your portfolio, making it worth holding onto.
Instead of blindly selling shares for tax purposes, strategically look for opportunities to use inadequate long-term performance as a means to reduce your tax burden.
6. Take Advantage of Smart Investment Opportunities
Smart-money investors — including big-money investors like George Soros and Warren Buffett — look at market corrections and crashes as investment opportunities. In 1996, Buffett said, “Be fearful when others are greedy, and greedy when others are fearful.”
Although that quote is more than two decades old, it’s still true today. If crashes are opportunities for the big wigs on Wall Street, they’re opportunities for you too.
Buy the Dip
Warren Buffett has a history of buying billions of shares of companies during a market downturn. It’s a profitable move too. He’s banking on getting in at lower prices as fear takes hold across Wall Street.
Buffett knows that a bull market is soon to follow any significant downward movement. If you carefully research each investment, specifically looking for quality stocks the market has undervalued, you can bank on the bull market rebound too.
Buy Index Funds
If you’re not comfortable buying individual stocks during a market crash, you can buy the dip of the market as a whole. Although some stocks may never recover, the market as a whole is known for bouncing back.
The best options for exposure to the entire market are broad-exposure exchange-traded funds (ETFs) and mutual funds, also known as index funds. These funds are created with diversification in mind and offer a low-cost way for you to invest in buckets of hundreds or even thousands of stocks at the same time.
Pay Attention to Mergers & Acquisitions
When the market is down and investors are fearful, larger companies are able to acquire up-and-coming companies at serious discounts. Moreover, companies that are willing to pay hundreds of millions or even billions of dollars to acquire another during a market downturn show financial strength.
At the same time, these companies are often undervalued thanks to a fear-stricken market that doesn’t include the value of acquisitions in their valuation analysis. When the recovery happens, these companies come out of the crisis stronger than ever before.
Use Dollar-Cost Averaging
There’s no way to accurately time the market. You don’t want to wait for a rebound and miss the best days, and you don’t want to buy too high and miss your opportunity to profit.
Dollar-cost averaging is the solution. By spreading your investments over time and making regular, equal purchases of a stock, you can be sure you’re not buying at the top or missing out on the rebound.
7. Prepare for the Next Stock Market Crash
This isn’t the first market sell-off and it’s not going to be the last. You don’t have to be caught off guard next time. There are a few ways you can prepare.
Diversify Your Portfolio
No matter how aggressive you are in the market, you should protect your investment portfolio value with diversification. If you have a healthy mix of domestic and international stocks, your international plays will help balance out losses in the event of a localized economic downturn. If you have a healthy mix of cyclical and noncyclical stocks, your noncyclical holdings will lighten the blow in the event of a local or global market downturn.
You can also take diversification a step further.
Consider investing in assets like real estate, precious metals, or even art. The stock market isn’t the only place you can find investment opportunities.
You shouldn’t wait for a stock market crash to rebalance your portfolio. If you have a passive portfolio consisting of ETFs, you should rebalance your portfolio at least once or twice per year, but there’s no shame in doing it quarterly or monthly.
If you have an active portfolio consisting of individual stocks and fixed-income securities, you should rebalance your portfolio far more often. Quarterly rebalancing is a must, but you may find more success doing it monthly.
No matter how you invest your money, if you maintain balance at all times, you go into the crash knowing your portfolio will protect you against significant drawdowns you can’t recover from.
Stock market declines are just part of the game. The market is dictated by fear and greed.In just about every area of life, reactions are exacerbated when emotions are involved. The market is no different.
Market crashes are nothing to be afraid of. Sure, they’re no fun when you’re in the teeth of a 30% fall from glory, but they present opportunities no other part of the market cycle does.
Think about it; you’d love to go into your favorite store and see a sign that says “everything 30% off.” For the savvy investor, a market crash is essentially the same thing on a grand scale.
The key in all of this is doing your research and making educated investment decisions with a level head. If you can do that, you can rest assured you’ll be just fine.