Will the stock market crash? This is a question we seem to get more and more from folks now that the major indices are sitting near all time highs, despite less then rosy economic news.
The question is often posed a little differently depending on who is asking. Some will ask “when will the stock market crash”, while others will ask “will the stock market crash again in 2021”. But essentially all of these are different ways that investors express worry about a sizeable drop in the stock market averages that will could have a big negative impact on their portfolio balance.
Stock market crashes are generally defined as a large and often unanticipated declines in stock prices. Such an event is the result of stock sellers overwhelming buyers because of an economic event that may play out over a couple of days or many months.
The most famous stock market crash over a one day period occurred on Monday, October 14, 1987, often referred to as Black Monday. Although scholars disagree on exactly what caused the stock market crash that day, what is undeniable that day is that the Dow Jones Industrial Average declined more than 22%. This was the biggest percentage one day drop in its history.
A more recent stock market crash occurring over an extended period occurred in early 2020 as investors started to anticipate the huge negative impact that COVID 19 was going to have on the world economy. Here the Dow Jones Industrial Average lost more that 30% in just a couple month period.
Despite the huge negative short term impact a stock market crash has on our net worth, in all cases all major indices went on to eventually reach new highs. If you were able to hold and not sell your stocks, the markets have rewarded you will an average return over the long run. But certainly, for the short term, stock market crashes can be concerning.
If we define a stock market crash as a greater than 10% decline in the averages, then we have hit that mark almost 40 times since 1950, or more that once ever other year. That statistic is going to surprise a lot of folks because it happens more frequently than most people realize.
Given that history shows a stock market crash (defined here as a 10% pull back in the market averages) occurs once every 20 months the likelihood that another stock market crash will occur in the not too distant future is high.
But this statement of the high likelihood of a stock market crash of 10% or more is not meant to scare people into selling all their stocks now and buying them back at a later date. Instead, the goal here is quite the opposite, which is to understand that stock market crashes are normal things that occur from time to time.
There are several ways investors can prepare for a stock market crash. These items will not stop you from losing part of your net worth in the event of a stock market crash but will reduce your losses and the associated pain.
Know that based on history, the stock market averages will drop 10% or more from time to time, often with little warning. These market corrections are typically short lived. If you are not the kind of person that can afford to lose that kind of money over a short period of time due to what would still be considered normal gyrations of the market, then perhaps you should not be investing in the stock market.
Or perhaps you are investing money that should otherwise be set aside for other purposes. We suggest that you should only be investing funds in the stock market after you have set aside six to twelve months of living expenses to cushion you against unexpected expenditures or a loss of a job, etc.
You should also keep in mind your financial goals. Making reactive or emotional decisions when things turn south won’t do you any good. If you stay true to your goals, you will always be making decisions in your best interest.
If you have not created your financial goals, visit our financial independence calculator to get started.
These silly speculative stocks will be hit the hardest when a stock market crash occurs, so best to stay away from them all together.
Instead invest in only the highest quality stocks with a strong management team and a history of growth. Planning to hold these kinds of companies for long periods of time (three to five years, or even more) is the way to build real wealth as the stock prices grind higher over time.
Examples of these kinds of companies include Mastercard, Google/Alphabet and Apple. All of these kinds of companies have tremendous brands, with decades of growth ahead of them. They will weather any storm that the stock market throws at them and will very likely be worth much more, three, five or ten years from now than they are worth today.
When the stock market averages are going up, using leverage in your brokerage account allows you to buy more stocks and as a result increase your investing profits. But the opposite is true in a declining market, where in the worst case scenario you will be forced by the brokerage firm to sell your stocks at a loss at the worse time.
Best for your ability to sleep well at night to avoid this stress all together by not using leverage.
Remember that investing in this kind of fund will reduce your stock market returns in an up market (because the value of the fund moves inversely to the stock market), but will cushion the reduction of your portfolio value in down markets.
No one likes to see the value of their brokerage account decline during periods of a stock market crash. If you’ve followed some or all of the recommendations above, you will be prepared for the inevitable stock market crash that will occur. But once the stock market crash has occurred here are some things to keep in mind and act on:
And while we would never want you to overload on any once stock, if the long term thesis of the business is still solid, why not buy a few more shares of a stock while the price is lower. Buying more of a stock that is trending down can be painful in the short run as the stock price could continue to decline after you buy it. But over the long run, buying stocks in a down market should reward you well as the share prices eventually recover of the highest quality stocks.
Summary
History shows that stock market crashes of 10% or more are going to happen from time to time. No one can say if the stock market will crash in 2021 or in any given year, but no doubt they will occur.
Don’t be afraid of these stocks market declines. Use them to your benefit to buy shares of high quality companies that you have been following at discounted prices.
Keep in mind that the stock market averages a return of 9% a year over the long run, but you need to stay invested in the down times (and not panic sell) to achieve those kinds of solid results. Don’t let a down market get you to sell out of the market.
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