How I’m preparing for the next stock market crash

A market crash is inevitable, thinks Paul Summers. Here are four ways he’s preparing for the tougher times that could lie ahead.

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From frothy valuations to rising inflation to the inherent ridiculousness of non-fungible tokens, it’s not hard to find indicators that a stock market crash may be on its way. And even if it doesn’t come next week, or next month, it will come. Here’s how I’m preparing for it.

Avoid the frothy sectors

No one wants to buy a stock just before it plummets. To keep the risk/reward trade-off in my favour, I’m therefore being careful not to throw money at shares trading at frothy prices. Many S&P 500-listed companies look guilty of this right now, particularly those which aren’t yet profitable. Renewable energy stocks also look priced to perfection.

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This isn’t to say an expensive share can’t get more expensive. Nevertheless, the more detached a stock gets from a company’s fundamentals, the lower my ‘margin of safety’ will be. This is why, from the perspective of risk, investing during a market crash will always trump investing when everyone’s toasting their portfolios.

Build a wishlist

Since no one rings a bell prior to a market crash, I think it’s a good idea to always have a wishlist of stocks I’d love to own, but are currently too expensive. This way, I’ll know exactly which companies I should be targeting when shares (temporarily) tumble and emotions are high. I’ll also be less prone to getting distracted by something mediocre. This is surprisingly easy to do when everything suddenly looks a lot cheaper.

Naturally, the companies that feature will be determined by the underlying strategy. At this stage of my life, I’m more interested in growth than generating income. I’m also a sucker for quality stocks. These are companies that generate high returns on capital employed (ROCE) or enormous profit margins. A leader in a niche market that has high barriers to entry is similarly desirable.

Have a cash reserve

Building a list of stocks to buy in the event of a market crash is all well and good. However, all this work will be wasted if I don’t actually have cash on hand to snap them up.

Sure, there are drawbacks to not being fully invested. Cash earns very little in interest. This means its value is eroded by inflation the longer I do nothing with it. It’s also psychologically hard to keep money in reserve when every other asset keeps rising in value.

So, how much is enough? Personally, I avoid sticking to a fixed percentage. Instead, I adopt an even more simplistic litmus test. If my cash/equity balance allows me to sleep at night, I’m probably on to a good thing. 

Keep buying

This final point may sound hypocritical, given the above. However, I do think it’s important to strike a balance between preparing for a market crash and being overly cautious. As master investor Peter Lynch once said: “More money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves.” 

On account of my lack of crystal ball, I’m still drip-feeding money into positions I already hold, albeit smaller amounts. Again, the risk/return must also remain attractive. Unless I spot a better opportunity, I’m also not selling anything I own either. 

Adopting a humble mindset and accepting what I can’t know for sure should mean I’m better prepared for whatever transpires.

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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