Following market commentary, it’s easy to drown in the noise. Some analysts are heralding the arrival of a glorious new bull market, whereas ‘bearish’ voices insist that a stock market crash is just around the corner.
So, who’s right?
There’s no way to know for certain. The direction of stock market volatility is notoriously difficult to predict, and I don’t have a crystal ball. However, I do have a plan to execute if share prices plummet. Here’s how I’m preparing for a stock market crash in three simple steps.
1. Keep cash on hand
I’m bullish on the stock market’s long-term prospects. Innovation, competition, and improvements in efficiency have helped to lift equities over long time periods historically. Although past performance doesn’t guarantee future results, the FTSE 100 index typically returns between 6% and 8% on an annualised basis.
However, there’s an investing adage that says stocks take the stairs up and the elevator down. Stock market crashes can be sudden and investors can easily be caught off guard by dramatic drops.
To mitigate such risk to my portfolio, I keep spare cash on hand rather than having all of my money invested in shares. There’s no right amount of cash to hold — it depends on each individual’s risk tolerance. However, when Warren Buffett has a massive $129bn cash position, I think it’s prudent to set aside some dry powder!
My cash allocation in the context of my investment portfolio is earmarked exclusively to take advantage of big share price falls. I keep a separate emergency fund in cash to cover any unexpected expenditure so I’m not forced to sell my shares at low prices.
2. Spot share price bargains
Each stock market crash has unique dynamics. They affect different companies and sectors to varying degrees. When the dotcom bubble popped, tech companies with lofty valuations came crashing down. In the 2008 financial crisis, banks were in the eye of the storm. The pandemic was particularly unkind to airlines and aerospace businesses.
Each of these scenarios presented unique bargains for eagle-eyed stock pickers. I can’t say with certainty the factors that will define the next stock market crash, but I can confidently predict that some good companies will be unusually cheap.
I maintain a watchlist of shares that I carefully research. In a downturn, I’d look for big share price falls in these companies, assess the risks, and aim to pluck up the courage to invest some spare capital with long-term returns in mind. Of course, it’s almost impossible to perfectly time the lowest price level, so I’d have to embrace the risk of further declines.
3. Remember, it’s not ‘all or nothing’
Finally, it can be difficult to keep emotions in check. I try to avoid exuberant optimism or excessively gloomy pessimism.
A crash could happen in 2023, but it’s far from certain. I’m not going to sell my shares and spend significant time out of the market in the hope of buying them again at lower prices. In doing so, I run the risk of sacrificing important gains.
So, I’ll keep investing in stocks with attractive risk/reward profiles as the year progresses. However, I’ll have some funds spare so I’m ready to pounce if the market takes a tumble.
