The words ‘stock market crash’ strike fear into the heart of many investors. Such crashes are not very common. While the market moves down from time to time, a crash is more than just a downwards movement. One common definition of a crash is a value loss of 20% or more in a short period of time.
I do not know when the next crash will be. Nor, in fact, does anyone. But it is bound to happen sooner or later.
Rather than striking fear into my heart, that could be great news for me – depending on how I choose to act.
Why a crash could be a great opportunity
What happens in a stock market crash?
The price buyers are willing to pay and sellers to accept for a share usually falls – sometimes dramatically.
But what about the intrinsic value of that share? Is it worth so much less than it was just days before?
Sometimes it may be. For example, if a bank run causes a stock market crash, bank shares might fall. That could reflect investors’ perceptions (or fears) that following a run at a competitor, a bank will lose some customers and its future profitability could be affected. In other words, a lower share price could simply reflect the fact that in light of events a reduced business valuation seems realistic.
However, that is not always what happens in a stock market crash. Take a look at the chart below showing the share price of Howden Joinery, for example.
Note the sharp fall in early 2020 when we saw a pandemic-related crash.
Did the pandemic affect the short-term prospects for Howden? Absolutely. Profits ended up falling 30% in 2020 compared to the prior year. But did the pandemic change Howden’s long-term prospects dramatically enough to see the sort of fall seen in the chart above?
Judging probabilities
We now know that the answer was no. If I had bought Howden shares in the March 2020 stock market crash, I could have more than doubled my money in only a year-and-a-half.
But in a crash one must make forward-looking decisions. In 2020 I did not have the benefit of hindsight about Howden I have now.
In practice that means that as an investor I try to assess probabilities. By sticking to businesses I understand when considering what shares to add to my portfolio, I feel better able to judge whether they may be affected by certain events. That can help me value them, so that if a stock market crash pushes their price down well below that value, I feel reasonably confident that I am eyeing a bargain not a value trap.
Getting ready today
That is why I try to invest only in areas I understand where I feel I can evaluate a company’s value and prospects.
My investing philosophy is all about trying to buy great companies at attractive prices. A crash that pushes down the share prices even of companies with broadly unchanged prospects could help me do just that, hopefully speeding up my efforts to build wealth.
