How to Prepare for the Next Stock Market Crash

The stock market is in an extended bullish phase that has seen the Dow hit all-time highs and then repeatedly break those records while going even higher. Inexperienced investors are thrilled and excited by that, pouring more money into the market as stock prices rise, hoping to strike it rich. Meanwhile, more seasoned investors tend to get a little nervous when everyone else is giddy and euphoric because they know that the stock market always retreats, and sometimes crashes, after a dizzying climb.

How long the bull market will continue is anyone’s guess, and right now could be a smart time to buy into it, but it could also turn out to be the wisest time to sell. We won’t know that answer until the future is here and we have the benefit of 20/20 hindsight. For that reason it is a good idea to begin now to put some contingency strategies in place so that you are not caught completely off guard and overexposed if the market does suddenly shift direction.

Respect History

An undeniable fact of any market is that what goes up must come down. The reason that stocks represent arguably the best, most profitable investment vehicle of all is not because they always go up, but because they always move in cycles of both upward price appreciation and declines in value. That may sound counterintuitive on the surface, but it’s those low-value valleys that make many, if not most, investors rich.

The poster child for that kind of wealth-building is the incomparable wizard of Wall Street, Warren Buffett. He became the most successful stock picker in history by buying stocks during bear markets. His focus is on quality, of course, and he wants to purchase top-shelf companies at rare, undervalued bargain basement prices. Then he holds them until market momentum shifts and the prices go back up again. Adopt that same risk-averse philosophy to enable you to buy low and sell high and you will also succeed as an investor.

Track the Russell 2000

You should also pay attention to the Russell 2000 Index. Although most people are not that familiar with the Russell 2000, investors should follow it closely. At times like these its performance may be a much better market barometer than the Dow Jones Industrial Average (DJIA) or Standard and Poors (S&P) 500.

  • The Russell 2000 Index follows the performance of the small-cap segment of the U.S. equity markets, so it is comprised of 2,000 of the smallest companies traded on Wall Street.
  • By definition, a “small cap” company is one that typically has a market capitalization of between $300 million and $2 billion. While that may sound like an awful lot of money, that amount is dwarfed by large cap stocks that are usually capitalized at $10 billion or more.
  • The performance of small cap stocks usually indicates the direction that large caps will soon follow. Historically the DJIA and the Russell 2000 basically move in tandem, while the Russell 200 typically moves slightly ahead of, and higher than, the DJIA in bullish phases.
  • When the Russell 2000 starts to fall, even if the DJIA is still moving upward, that can be a red flag that a serious correction is about to happen. Right now, in the spring of 2014, that kind of divergence is already happening as the DJIA goes up, but the Russell 2000 has fallen substantially.

An equities strategist at Wells Fargo Securities pointed this out recently on the CNBC TV program, “Nightly Business Report”; “Given that small caps have consistently outperformed the large caps for the last five years, and historically lead the large caps,” she explained, “it’s a little disconcerting.”

Limit Your Risk

To control the risk of a huge loss if the market experiences a substantial correction or a crash, you may want to place what is known as a “stop loss” order with your broker. Say, for example, that you buy a stock for $40 and want to hold it for capital appreciation, but do not want to risk losing more than 10% of your investment. In that case you can place a stop loss order at $34 (15% below $40). Should the share price ever hit that target it automatically triggers an order to sell immediately at the best available price.

As the old saying goes, “Nobody ever went broke making a profit.” In order to realize an actual profit when selling shares of stock, though, you have to do more than just sell for a higher price than what you paid for your stocks. That’s because you also have to consider sales commissions. Each time you buy or sell you incur those fees, so add them up and add that to the cost of your shares to find out exactly what price point represents a net profit.

Also consider the tax implications, because the capital gains taxes on short-term holdings can undermine your profit margins, whereas taking a loss on a long-term holding may provide you with a valuable tax deduction.

Don’t Resort to Panic Selling

When stocks continue to set all-time records and generate attractive profits it can be very alluring. In fact, bull markets usually have a contagious effect. People who may have never owned a stock see how much money others are making, so they jump on the bandwagon. Those same emotionally-driven investors are likely to panic if the markets experience a sell-off, however, and that guarantees a substantial loss.

To avoid getting caught up in the emotional roller coaster of the stock market, decide what your specific financial goals are for owning stocks before you buy them. Ask yourself things like:

  • What kind of stocks do you need to help meet those goals?
  • How long will you hold them in order to reap the most benefit?
  • How much cash do you need in order to capitalize on market sell-offs that offers a chance to buy quality stocks at a deep discount?
  • What is the best way to diversify your holdings so that if one industry or type of stock experiences a sell-off, then other stocks you own will balance out those weaknesses to insulate you from stock market volatility?

Consult with one or more financial experts and a qualified tax planner to come up with an appropriate game plan. Then stick to it, but also perform an annual review so you are able to navigate extreme fluctuations and maintain a steady investment trajectory toward your long-range financial goals.