According to Standard and Poor's, the S&P 500 is down 40.29% for the year. And just in case you thought that was a typo, I'll repeat myself: the S&P 500 is down forty point twenty-nine percent so far in 2008. Ouch! Now here is something that is far more important. How you handle your stock market investments during a market crash is arguably the single most important determinant of your investing performance over your lifetime. In other words, the investing decisions you make during a market crash will impact your investment returns forever. And, if you make the right decisions in a falling market, you can profit handsomely. The fact is, however, that many people lose money (and lots of it) during a stock market crash, but it does not have to be so. So lets take a look at what's going on here, and how we can profit during this (and any) down market.
Investors are scared of the stock market
There is a simple reason why so many investors and even professional money managers are scared of the stock market--in the short term, stock prices seem arbitrary. Up one day and down the next, watching the ticker every second the market is open can cause one to wonder just what in St. Peter's name is going on. Warren Buffett described this phenomenon like only Warren Buffett can:
In the short run, the market is a voting machine but in the long run it is a weighing machine.
Actually, Benjamin Graham first said this, and it has stuck with Mr. Buffett, who repeats it often. But the wisdom behind this statement should be taken to heart.
In the short term, stock prices reflect all kinds of noise. The Fed Chairman says this or that, and stocks fluctuate. Unemployment numbers come out, and the market reacts. A politician says something to get elected, and the stock market traders do their thing. The point is that in the short term (I'd say 1 year or less), stock prices are often the result of factors that do not bear on the long-term value of the enterprise.
When viewed long term, however, the market truly does reflect the underlying value of public companies. By long term I mean really long term (10 years or more). Stocks can be undervalued or overvalued for a decade (see 1960s or 1990s). But given enough time, stocks will reflect the underlying value of the corporation that issued the security.
Investors sell on fear and buy on greed
While most would not quarrel with the above comments, many do not take them to heart. It is not easy to hold on to your investments when they fall 40%. You start to lose confidence in your investing decisions. Then you start to wonder if there has been some seismic shift in the markets.
Remember the Internet bubble? I recall investors talking about how the world was totally different with the Internet, and they used this lie to convince themselves to buy stocks of dot com companies with zero revenue. Remember the housing bubble? Folks would tell me that they are not making any more land, so prices must keep going up. Those folks are renting now and proclaiming that owning a home is NOT the financially prudent thing to do. Oh, brother!
The point is that many investors do exactly the opposite of what they should do. When stocks are going up, they buy, buy, buy. When the markets crash, out of fear, they sell, sell, sell. All I can say is that this is wrong, wrong, wrong.
Timing the stock market is a fool's game
I have a friend who sold all of his equity investments (a 7 if not 8 figure portfolio) earlier this year before the market crash. At a party at his house the other day, friends were congratulating him on such a wise move. So I asked him if he was going to get back into the market now. He said no. Then I asked when he was going to get back into the market. He did not know. So I reminded everybody that his decision to sell will have been a good one only if he buys at the right time, too.
Successful market timing requires you to be right twice--once when you sell, and once when you buy. And over the lifetime of an investor, you must be correct over and over and over again. Good luck.
How to profit from a stock market crash
The simple and easy way to profit from a stock market crash is to do one of the hardest things in life: nothing. "Don't just do something, stand there!" is the best strategy, in my opinion. Of course, this assumes that your asset allocation plan is appropriate for your investing horizon and risk tolerance. It also assumes that your investments have gone down because the market has gone down, not because you invested in some silly dot com company with no revenue.
So that's what I've done. I've not changed my asset allocation plan. I have continued to invest on a regular basis just as before. I've only sold one fund, and that was for tax reasons. The proceeds will be going right back into the market to maintain my asset allocation.
A side benefit of a market crash
One last thing. A market crash presents a great opportunity to determine just what your risk tolerance is. Many mutual fund companies and brokerage houses offer a short survey to help you determine your risk tolerance. The survey asks questions like what you would do if the market fell 20%. Would you sell, do nothing, or buy. Once you've answered these questions, the survey suggests an asset allocation based on your answers.
Those surveys are all well and good, but there is nothing like losing $10,000, or $100,000, or even $1 million to really gauge your risk tolerance. So after this market crash, you should know your risk tolerance very well. If you sold your investments over the past month or so, you make want to revisit your asset allocation plan. It may have been more risky than you can bear.
Sound money management includes investing for the long term. As difficult as it may be, this means not making investing decisions based on fear. So let's hear how you have handled your investments during this down market.
{ 12 comments… read them below or add one }
You make some excellent points in this article. I believe that one of the most important things you can do for yourself in a stock market crash is to have a good understanding of exactly what you’re getting into, that is are you investing or are you speculating. I just finished reading The Big Gamble and it really opened my eyes as to the differences and how to use this new knowledge to invest successfully during these poor economic times.
I congratulate your friend on unloading before the crash. If he did it by dumb luck, he won’t get back in at the proper time. If he did it following good analysis, don’t worry , he will certainly re-enter at the proper time. ” buy and hold” is “buy and hope “-very hard on the nerves as well as the pocket book!
I, like most, invest through my 401K, dollar cost averaging. Naturally I just increased my contribution. We will likely never again get a chance to invest at DOW 9,000 (or 8,000). In 5 years, when the DOW is sitting at 20K or above, we can sell at our lesure.
Bottom line: it’s easier to buy at the bottom than sell at the top, so right now buy with everything you possibly can!
only those people can get benefit from Crash Stock exchanges who were away before crash. But if some one is involved in buying and selling then there is no way one can get away from losses. It’s like a settling elephant, when he sits many lilttle ones get smashed.
Any ways thanks for sharing your view. Although you are not a financial expert.
I totally support the view of Martin, only well informed and wise stock brockers/ investers took their money away from the market. Other wise there’s no chance of escaping from the Financial Tsunami.
Ha ha ha I like the term … Financial Tsunami…..
The captal market will come back and soon every thing would be fine and many new enterants will see the new era.
Congratulation ……
Barak Obama is new President now. Stock Market crises gonna over now
This article did not define what the indicators should be when the stock market turns from bad to good. Getting back in at the proper time is critical. The economist for example only realize when the market is good or bad a year after it started. Should we be waiting for it to reach 9000 points? Maybe it should be after profits for the company you like to invest in start going up. Should we watch the amount of raw materials sales such as iron, copper, cement and wood? Maybe it is something else?
There’s a global food shortage in case you haven’t heard.
Global food shortage + global financial meltdown + natural disaster or a big September 11th type attack will render all of of the financial assumptions listed above as worthless… financial planners the world over will be wheeling their wheelbarrows full of their share market portfolio certificates around, desperately hoping to trade paper for food.
If you want to eat stock certificates then that’s your business but if I had money to invest right now I’d buy grain and then gas it so it can be stored for the medium to long term. Then I’d quietly go about my modern Western lifestyle, suffering on through this downturn, knowing that my investment is actually worth something compared to the hype of shares.
Hahaha, what a piece of bull, this is kind of con game article that’s has been circulating ever since the inception of the mutual fund investing for suckering uneducated investors in. Yes, stocks eventual do go up, but it’s literately a ponzi scheme, where the initial schemers and insiders already know when to pull the plug, and the retail investors always get the short end of the stick. Notice that stock has to go up because the paper money value over a long period of time keeps going lower and lower, so how’s that gonna make anybody any money when your one dollar is worth a lot less in next ten year’s time? Besides, the stock is a non physical paper note or a digital blip, nothing more, you are paying your hard earned money into this gigantuan con and you have no control over when the insiders gonna do to your money. These people know what much you pay for the stock and how much they would cut you under. The underlying value, PE ratio, fundamentals of the company is irrelevent, because it’s all an illusion and cooked books. I rather buy an antique then buy a piece of stock of which it has not value whatsoever….. but …..shhhhh….. don’t tell that to the million of 401k suckers…..
I don’t agree with your advice to do nothing when the market crashes. I say first decide if have enough money to live on if you lose your job. Then throw the rest of the money in the stock market once it falls 40% or more from its peak. Those are some great buying opportunities. That’s what I did, and it worked.
Of course, you don’t want to marry a stock. Diversify and invest with in mutual funds or ETFs. You can double down on stocks as long as you’re diversifying.