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How to prepare for a stock market crash

How to prepare for a stock market crash

May 17, 2018

I often get the question from friends and clients: “What should we do about the coming market crash?” The long-term clients I’m blessed to work with already know my answer: “Nobody can predict a ‘coming crash’ so we need to own investments that are consistent with our three-year and longer goals. By doing that, we need do not need to worry about the next crash.”
Chances of a stock market crash
Most people drastically overestimate the likelihood of a major bad economic event.
Nobel Memorial Prize-winning economist and Yale University professor Robert Shiller has been asking individual and institutional investors about this subject for almost 30 years. He asks them about the odds of a stock market crash like those on Oct. 28, 1929, and Oct. 19, 1987 — the two biggest one-day drops in U.S. stocks ever — in the next six months. He has found that retail investors consistently give the odds of a crash at between 10 percent and 20 percent.
However, statistically, it’s around 1.7 chances in 100. The last time we had a major one-day decline of more than 20 percent was more than 30 years ago. So it’s actually very rare.
This disconnect between the actual risk of a market crash and people’s fear of a market crash is fascinating to me. It’s a reminder that human nature and the powerful instincts we have that drive our real-life choices can be pretty silly some times.

Behavior gap for investor returns
Since we think bad things happening in the markets are far more likely than they really are, we are tempted to try to protect ourselves from these bad things by making changes or adjustments to our investments.
Research from DALBAR has shown the real-life returns people get when they buy and sell investments is far short of the total return earned by the S&P. Over 30 years, investors manage to earn about 4 percent from investment in stock funds while the index averages about 10 percent. The 6 percent difference is something I call the Behavior Gap.

© Real Investment Advice
One of my goals as a CERTIFIED FINANCIAL PLANNER™ professional who acts as my client’s advocate at all times – a fiduciary planner – and who only gets paid by my clients – a fee-only planner – is to help clients realize a larger share of the 10 percent average return the market could deliver.
Part of the challenge is that the market index does not really exist in the real world. For example:

  • The index does not have junior high age kids who need to pay soccer league fees.
  • The index does not have a home that needs a new furnace this year.
  • The index does not get laid off, or promoted, and realize an unexpected change in income.
  • The index does not have any trading costs or advisory fees.
  • And my favorite: The index does not pay taxes.

How to create a financial plan
My point here is that managing your investments in general, and protecting yourself from the next market crash in particular, is a process that takes place inside your larger financial game plan and needs to be guided by your goals and priorities. It’s simply not a one-size-fits-all situation.
This is yet another reason to find a great financial planner you trust and start working on a comprehensive financial plan that will move you safely and predictably toward your financial goals. Such a plan takes into account how much time you have with which to work. It will incorporate specific strategies to protect you from unpredictable bad things that could blow up your plan. And it allows you to see how you are doing and what comes next. That’s really the very best way to be ready for the next market crash.
If this article has you thinking about your own circumstances, contact my office at rdunn@dunncreekadvisors.com. I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.