History suggests that a stock market crash, or a 20% drop in the FTSE 100, happens once every seven years. Since the last one was March 2020, it is unlikely that a large crash will occur any time soon (if we’re going by the historical average).
However, minor pullbacks in the FTSE 100 happen much more frequently. Data suggests a 5% fall or more in the Footsie happens 1.5 times a year. With the last 5% fall in the FTSE 100 in January 2021, some may argue a minor fall is around the corner. Whilst a 5% drop is hardly a ‘generational buying opportunity’, it would be a fantastic time to put cash to work.
So how do I prepare for a fall in the price of the FTSE 100 and benefit from it?
Keeping a cash reserve
Given how volatile the FTSE 100 can be, I always keep between 5% to 10% of my portfolio in cash. This percentage changes based on my view of the market and whether it looks cheap or not. For example, the cash reserve generally falls to 5% or even 0% when the market drops significantly. Meanwhile, when the market looks expensive, this cash reserve could rise as high as 10%.
Keeping cash reserves also serves psychological benefits. Knowing that I have a cash buffer keeps me calm when the market drops, as I can keep buying and averaging my positions down.
Ignoring the noise
Minor corrections or crashes in the FTSE 100 are normally paired with a scary headline and a reason to panic-sell. If history is a good indication, it usually is wise to ignore these headlines and stay invested.
An excellent example of this was in 2015 when worries about a slowdown in the Chinese economy caused a fall in the share price of commodity producers. This event led to a 15% fall in the FTSE 100, with commodity producers like Anglo American falling over 30%. This fall scared many unprepared investors out of the market, only to see the FTSE 100 make new highs a year later.
The moral of the story is that it is usually best to stay in the market and invested heavily. For individual stock investors, it also helps to understand the businesses exceptionally well. This helps me stay calm and invested when the share price drops significantly.
While a 20% crash in FTSE 100 is unlikely, a small 5% drop is arguably always just around the corner. In preparation for a minor correction, I have a wish list of companies I would like to buy at a lower share price, keep a small cash reserve, and stay calm when it happens.
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Harry Godfrey 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.