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Today is the 26th anniversary of the 1987 stock market crash. On that day, the market plunged more than 22 percent. While the ’87 crash is a distant memory, it serves as a good reminder that the market doesn’t always go up. More importantly, how prepared are we to handle a market crash?

I can remember in 2011 when the market declined and investors rushed into Treasuries. The result was that U.S. Treasury debt prices soared (sending yields crashing) as investors fled equities. This reaction to the market in 2011 was exactly how long term investors should not react for several reasons:

  1. Timing the Market: I’m always amused when some mutual fund manager is interviewed on TV, and his credentials are the fact that he “predicted” the stock market decline or the housing crash a few years ago. Experts are always predicting something, and some of them are bound to be right some of the time. But for market timing to work, you need to be right all of the time. Maybe you’re that good; I’m not.
  2. Investment Horizon: I won’t need my investments for at least 20 years. As a result, what the market does today, or this week, or this month, or even this year doesn’t much matter. Of course, if you are about to retire or are in retirement, the current market may be very important to you. But if so, your asset allocation should reflect your financial needs such that more of your money is in income producing investments, rather that equities.
  3. U.S. Treasuries: Although U.S. Treasures are still viewed as a safe investment, I think they are largely a terrible investment. Many 1-month T-bills yield between 0.003% and negative 0.003%, according to the Wall Street Journal. And given our debt, deficits, and unwillingness to meaningfully address either, I don’t see U.S. Treasuries as the sound investment they once were.

Here’s the reality–the time to prepare for a stock market crash is before it happens. As investors, we should expect to see market corrections periodically. Just having that expectation is the first step in dealing with market declines like we saw today (in Scott Peck’s words, life is tough. And as soon as we realize it’s tough, it gets easier). But the question remains, how should we prepare for the inevitable market declines. Rather than fleeing the stock market like a rat from a sinking ship, I prefer to make sure the following things are in order:

Asset Allocation

As I’ve written before, asset allocation is making sure you don’t keep all your eggs in one basket. For most, asset allocation means investing in both stocks and bonds, and for each, both domestic and international offerings. An asset allocation plan can be a lot more complicated, but it need not be. The key is determining how much to put in stocks versus bonds and domestic versus international investments. Some time ago I wrote an Asset Allocation Guide that covers investment plans for all ages.

The proper asset allocation won’t insulate investors from losses. But it should protect investors from unacceptable losses given their financial circumstances. And as important as an asset allocation plan is, don’t forget to periodically rebalance your investments.

Emergency Fund

It may seem odd to talk about an emergency fund in the context of a stock market dive, but they are related. The goal is to arrange your finances so that a steep sell-off in the market does not cause investors to sell in panic. And a great way to keep your cool is to have a healthy emergency fund in a high interest savings account. If you are using your investments in the stock market as your emergency fund, you are far more likely to sell when the market plunges.

Manageable Debt

Managing debt is important for everybody, but it’s particularly important as you near retirement. While you can’t snap your figures and get out of debt overnight, you can take meaningful steps to reduce your debt. By reducing your debt, you also reduce your monthly financial needs. And if you are relying on stock market investments to pay off debt, you’re making a big mistake. The stock market should be seen as a long term investment (10 years or more). For debt payments that need to be made now or in the near future, the money should either come from employment or , if you are in retirement, risk-free investments.

And if you manage your finances appropriately, you can even profit from a stock market crash.

As a parting thought, here is some Warren Buffett wisdom to see you through the market turmoil: “In the short run, the market is a voting machine, but in the long run it is a weighing machine.”

Article comments

Super Saver says:

Before 2008, I would have agreed with you. But after seeing the decline in the stock market after TARP passed, I believed the market would decline whether a debt crisis was averted or not. So I converted a significant part of our investments to cash in early June 2011.

I think many investors still remember 2008, which will lead to a selling frenzy. This will create a great buying opportunity in the future 🙂

DR says:

That’s certainly an approach many have taken. Selling in June 2011 was good timing! I hope you time it right when you buy back in.

Emily says:

We keep our investments in mutual funds that have a great track record. Including 2008, most of them average at least 12% annual return.

DR says:

Emily, what funds did you have in 2008 that earned 12%???

jim says:

I had some money in cash in my Roth IRA and after yesterdays market drop I figured today would be a good day to buy. So I took most of that money and bot a Vanguard index ETF with it. Yeah its market timing in a way but I figure that I needed to use that cash to buy sooner or later and the day after a sharp drop seemed like as good as time as any.

My wife had the good sense (or luck) to pull all her 401k funds out of stocks before the 2008 plummet. However she wasn’t as lucky (or skilled) to know when to reinvest the money at the market bottom and so the money has sat in the stable value fund ever since. You have to be able to successfully time the market twice in a row for it to work right.

DR says:

Jim, that’s why I don’t time the market. As you say, you have to be right twice each time you try. I’m just not that lucky or smart!

Another use of the emergency fund is not only to allow a liquid pool of assets for you to use in case your assets crash, but also so that you have funds available so that you can subsequently invest more into the market when it goes down. It’s buy low, sell high, right? It might even be worth it to keep two savings accounts, one as a true emergency fund and one as cash for investments when the market crashes since most brokers don’t offer very good interest rates for cash right now.

I always run into this problem with my IRA since I’m still only a year out of college. My total value is too small to really keep any cash, but I’m banking on the fact that I have 30-40 years left until retirement in which case the dividends and capital gains should more than make up for any gains I would obtain from essentially dollar-cost averaging by buying on a crash.