When times are good, it’s easy for an investor to forget the potential downside of share investing. Monday was a painful lesson and a mini reminder of what could happen in a stock market crash, only it would likely be much more damaging.
Given stock market corrections and crashes are unavoidable, here are three ways I’d prepare for the next one, whether it happens this year, next year or further in the future.
Keep some cash for a stock market crash
One of the key ways to prepare for any eventuality, including a stock market crash, is to keep some cash aside. As the saying goes: cash is king. However, keeping too much cash uninvested also limits the money that can be made if markets are rising before a slump or crash. Therefore, there’s an ‘opportunity cost’ to not investing cash.
This is why I’ll usually keep about 5%-10% of my portfolio as uninvested cash. That way I can pick up shares much more cheaply just after a crash. That would then power my gains in the almost inevitable post-crash recovery. By being mostly invested though and not holding too much cash, I can also have a portfolio of companies I want to be invested in. That should provide dividend income and capital growth.
Invest in quality companies
Alongside having cash available to limit losses and deploy post-crash, one of the other ways to be in as strong a position as possible going into a crash is to invest in high-quality companies. What I think this means in practice is investing in shares that show high returns on capital employed, high margins, low debt and growing revenue. Any company that can combine these and also be in an industry with good growth prospects ought to come through any stock market crash.
The opposite is true of highly indebted companies with weak business models. It’s conceivable that another bad crash could, for example, sink a stock like Cineworld (at least in my opinion).
Have a diversified portfolio
The third aspect of preparing for a stock market crash is to have enough investment diversification. That cuts both ways though, because I don’t want to be over-diversified as research shows this can limit gains and I’d be better off probably just buying an index tracker.
Diversification is best achieved by investing in different industries and across geographies so the country risk is minimised. Good diversification is about holding a portfolio of stocks that aren’t all very similar in terms of market cap, valuation, industry they operate in and countries they’re based in or sell in. A well constructed portfolio of high-quality stocks should weather a stock market crash better than a less diversified mix of stocks.
My portfolio already follows these rules and I think it means I can make money when stock markets rise, but also limit my losses and then pick up shares more cheaply when there’s a stock market crash.
