It is a strange thing, but when you are dreading something, and would give anything to slow down time, it has a disobliging habit of speeding up. — J.K. Rowling, Harry Potter and the Goblet of Fire
Investors dread stock market crashes. Dreading them doesn't speed up their occurrence, but they will happen now and then. It's important to respond to them well, lest we lose a little — or a lot — of money. Here are five steps to take if the stock market drops in the near future:
1. Stay calm
For starters, don't panic! The stock market is simply going to drop in value on occasion. On relatively infrequent occasions, it can drop a lot. In the 150 years since 1870, the S&P 500 fell by 30% or more 15 times, or about once a decade on average. The market has always recovered from its falls. These recoveries usually happen in a matter of months, though sometimes they take many years. That's why you don't want to park any dollars you expect to need in five or perhaps 10 years in the stock market.
Many investors panic when the market drops and sell some or all of their stocks. That means they're settling for low prices and possibly even significant losses, when if they'd just hung on, their stocks would likely have recovered.
2. Look for bargains
Super investor Warren Buffett famously quipped: “We [he and partner Charlie Munger] simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” A stock market crash is the classic period of fear — meaning it's a great time to be greedy. Snap up shares of companies you've long wanted to own when they briefly fall to attractive levels.
Ideally, you'll have a watchlist of stocks at the ready to reduce the amount of hunting and research you'll need to do at such times. Not every stock of interest will fall to an attractive entry point, but many probably will.
3. If you're retired, withdraw less from your nest egg
What if you're not in growth mode anymore? What if you're retired, investing to maintain a nest egg that has to support you for the rest of your life? Try to withdraw less from your savings than you planned. When the market drops, the value of your stock holdings will also shrink. Taking out your usual amount will leave your nest egg smaller than it otherwise would have been. A smaller nest egg will also grow less in the coming years.
4. Position yourself well for the next market crash
This is a fine time to position yourself well for the next stock market crash:
Establish an emergency fund with at least three to six months' worth of living expenses.
Pay off high-interest debts as much as possible to strengthen your financial condition.
Diversify your portfolio and ensure you don't have too many eggs in any one basket — one stock, one industry, one asset class, etc. Rebalance your portfolio in the days or months ahead and get back to your desired asset allocation.
Consider cash. Accumulating cash and keeping it on hand can help you pounce on opportunities that a market crash presents. You may see lots of bargains, but without cash, you may be unable to buy them (or you might have to sell some other stock at a big loss to generate the liquidity).
Build that watchlist of great stocks you'd like to buy at good prices.
5. Consult a professional (or two)
Finally, understand that reviewing and possibly restructuring your finances are big jobs. If you're not comfortable with it all, get a second opinion (and possibly a third) from a financial advisor. Having your finances reviewed by an expert can give you peace of mind. Look for a fee-only one who doesn't have conflicts of interest, such as commission rewards for putting you into certain investments. Find one near you by visiting the NAPFA.org website.