Are You Prepared For A Stock Market Crash?

The old saying ‘revenue is vanity, profit is sanity, but cash is reality’ holds true in business. In other words, while sales growth can boost egos and profit can put your mind at ease, what really matters is cold, hard cash.

The same is true in investing. It may feel good to have made paper profits on shares, but they mean little until they’re sold and the cash is in your hand, ready to be invested elsewhere or spent on something else. Similarly, while it’s always difficult to come to terms with paper losses, shares falling due to macro factors tend to come back in the long run before such losses are realised.

Keep some cash

With the stock market having fallen considerably since the turn of the year, those investors with cash are in a very strong position. They have the opportunity to buy shares at a vastly discounted price to their value of just a few weeks ago, or they could choose to wait for an even lower price before piling-in. Investors who are fully invested, of course, don’t have that option and are therefore forced to yield to the market’s movements.

As a result, it seems logical to hold at least some cash even during the best and worst of times for the stock market. The amount will clearly vary depending on the individual. But as well as allowing you to take advantage of a falling market, it also provides an investor with the peace of mind that if share prices do fall and paper losses are sustained, it could prove to be a blessing in disguise in the long run. In other words, keeping some cash on hand can help to keep an investor thinking logically during difficult periods for the stock market because they know they have the opportunity to take advantage of falling prices.

Dividends rule

This idea further enhances the view that buying high-yielding stocks is a good idea. That’s because shares that pay a generous level of dividends provide an investor with a source of additional cash flow, which can then be reinvested during the low ebbs of the market cycle.

Add to that a resilient dividend from a defensive stock such as a utility or tobacco company and the prospects for increases in cash during even the most difficult market conditions are boosted yet further. And with many companies increasing dividends at a rapid rate, a 4% yield can quickly turn into a 5% or 6% yield over the medium term, thereby increasing an investor’s cash flow even more.

Of course, holding cash during bull markets leads to lower overall returns than would be achieved if an investor was fully invested. That’s because cash returns are lower than shares in the long run. However, given the peace of mind it provides as well as the opportunity to buy during bear markets, keeping a small portion of your total portfolio in cash seems to be a prudent way forward.

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Apple. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.