Editor’s note: This story originally appeared on The Penny Hoarder.
The S&P 500 was hovering around record highs as of August 2021. But a lot of things can disrupt the economy, like the delta variant of COVID-19 and supply shortages that are making prices for just about everything soar during the pandemic. With so much uncertainty around, you might be worried that the stock market is going to crash again.
First, the bad news: Yes, the stock market will crash again at some point. A stock market crash is perfectly normal. The stock market has crashed 21 times – defined as a fall of 20% or more from its peak – since the Wall Street Crash of 1929. It is bound to crash at some point. We just don’t know when.
Now the good news: Historically, the stock market has always recovered over time.
The problem is that a lot of people don’t start thinking about how to prepare for a stock market crash until after the market has already crashed. But if you take action now, you will mitigate the damage later. Keep reading for five ways to prepare for a stock market crash.
1. Don’t try to limit your exit time
Some people try what is known as market timing, which means that they try to cash out their investments before the market crashes. Or they don’t invest when stocks are going up because they think the market is overvalued.
The problem is that even the best minds on Wall Street can’t anticipate the highs and lows of the market. The stock market can stay hot for a long time. If you avoid investing out of fear or because you hope to invest when the market goes down, you could lose significant gains.
A better strategy is to practice averaging the cost in dollars, which means that you invest a set amount at regular intervals. If you’re investing in a 401(k) plan or similar employer-sponsored retirement account, you’re already doing so because you’re investing money from every paycheck. The same goes if you automatically invest each month in a Roth IRA or a traditional IRA. Over time, dollar cost averaging tends to produce better returns than trying to time the market.
2. Build your own emergency fund
An emergency fund is the best investment you can make if you are worried about a stock market crash. You need a cash cushion in case you run into big expenses or lose a job right after the market goes down. Otherwise, you may have to indulge in a 401(k) or other investment before they have time to recover. If you are under 59, you may also face early withdrawal penalties.
If you haven’t had an emergency fund for at least six months, make building one a top priority. Of course, this is a long-term goal that may take years to achieve. But any safety net you can build is a victory.
Try to set aside at least 10% of your salary for emergency savings. If that’s not possible or you want to speed up your progress, taking a side stance to build up your reserves is a good strategy.
If you are nearing retirement or have already retired, it is especially important to make sure you have ample cash reserves. An ill-timed meltdown can ruin your retirement plans by forcing you to sell investments before you recover or claim Social Security too soon.
Consider meeting a fee-paying financial advisor if you are retired or plan to retire in the next five years. They can help you decide how much cash you should have and whether you have the right ratio of stocks versus bonds.
3. Select individual stocks at 5% of your portfolio
Maintaining a diversified portfolio is essential to counteracting a stock market crash. If you invest in individual company stocks, try to limit any individual investment to no more than 5% of your total portfolio.
When you invest in stocks, you risk losing money just because the market is down. But the risks of investing in individual stocks are greater compared to investing in index funds that move up and down with the stock market as a whole. For example, there is a risk that one industry will be hit particularly hard, as happened with tech stocks during the Internet crash, and risks that are specific to the company, such as poor management decisions or increased competition.
4. Rethink risky investments
If you have made a lot of money on risky investments like meme stocks (like GameStop and AMC), small stocks or Dogecoin, think carefully if it’s time to sell. There is nothing wrong with investing a small amount of money in a high-risk investment, provided you have sufficient savings and do not have high interest debt. But these investments are highly volatile, so your losses can be especially severe.
5. Decide now if you want to invest more
The stock market crash can be a great opportunity to invest more if you have the guts to do so. Provided you have a strong emergency fund and are investing for retirement, you can set aside additional money to invest when the stock market crashes.
Because it’s normal to panic when stocks go down, make a plan now. For example, you can decide that you will invest a certain additional amount if the S&P 500 drops below 4000. Or if there is a stock that you want to buy, you can decide to buy it if the price falls below a certain level.
This may seem counterintuitive to what we said about not trying to time the market. To be clear, saving money to invest when stocks are down is a strategy you should only use if you’re already an average dollar coster by investing for retirement. But if your finances are in good shape and commensurate with your tolerance for risk, it’s okay to prepare for some bargain hunting the next time stocks go down.
What should you do when the market crashes?
What should you do when the market crashes? Maybe nothing. A stock market crash leads to panic, but it’s best not to make major decisions about money from a place of fear. Continue investing in your 401(k) after the crash unless your financial situation changes significantly. Avoid checking your account daily.
It is never a good idea to see a decrease in your net worth. But if you don’t sell your investments at a loss, you won’t really lose money. With time and patience, your money will eventually recover.
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