What Happens When The Market Crashes?
I hope you haven't been paying attention to the financial news. I've advised against it before. I also hope you haven't been thinking about when to get in or out of the stock markets. I've advised against that. I've even told you to stop watching what the market is doing.
Nonetheless, even if you keep to yourself and enjoy your life doing the things you love doing, it's hard to ignore headlines such as, "5 Ways To Protect Against A Market Correction," "How To Invest In An Overvalued Market," "When You Can Buy Stocks On The Dip,", or "All Signs Show The Market Is Overvalued."
These attention-grabbing headlines sell ads and generate clicks, but they aren't advice. There are many out there who are very good at manipulating our emotions and fear is a big one. "What if the market tanks?" they'll ask us. They ask us what we're going to do if this happens or if that happens. Effectively, they scare us.
Better Approach
Instead of reacting to the news and markets, and instead of trying to outsmart and predict the markets, we should use the markets to our advantage. We will make no predictions about the future. We'll just prepare for it.
The Set Up
First we need to figure out what is important to us. Why are you saving and investing? What do you want to do and why? We have to first answer these questions for ourselves. Write these answers down; we'll use these answers when the markets turn scary.
The Portfolio
Portfolio is a fancy way to say your investments. This includes our savings accounts and savings bonds, too. To put together a portfolio we'll use globally diversified investments that are low-cost. Let me take a minute to decode that. Diversification means that we spread our investments around so that we don't have too much of one kind of risk. Global means that we should be investing in companies across the globe. And low-cost means that we don't want to pay too much to the mutual fund or ETF companies for access to these investments; we should look for low expense ratios, diversification within the funds, and low turnover (they shouldn't trade too much).
Asset Allocation
Asset allocation is an important decision that we make with our portfolio. It literally just means the allocation of our assets. We determine what percentage will be put in stocks, bonds, and cash. We take our time figuring this out because we don't want to have money that we need in the short run to be invested in stocks. Stocks are long term investments. We also have to get really honest with ourselves and figure out how much stock exposure we can handle. If you are someone who is glued to the news and reads the kind of articles I talked about above, then you should have less in stocks. If you are an excitement junkie and understand the long term nature of stocks, then you can afford to have more of your money in stocks.
Behave
Now that we know what percentage of our money will be in stocks, bonds, and cash, and we know what kinds of investments we will use to get access to these investments, we are ready to sit back and behave.
There is something very important to understand; when you put your portfolio together, you are putting it together knowing that there are going to be scary markets. That's why we diversify. If the US markets aren't doing so well, the stocks from foreign countries might be doing better; or bonds will.
"This Is Normal"
So what do you do if and when the US markets fall? You remind yourself that this is normal, and that you knew this was going to happen. Acknowledge your emotions, and realize that you are not alone. Remember when I told you to right down what was important to you and why you are investing? Go grab that paper and remind yourself. Remind yourself that you are investing for your lifetime, and what the markets are doing this year don't matter...even if it seems scary.
It actually gets better, because we have a great tool available to us to capitalize on bad markets.
Rebalancing
Above I said that we should be putting together an asset allocation. This represents what percentage of our portfolio should be in each type of investment. We should also choose a range around each of those percentages within which the actual percentages can float. We do this because each type of investment behaves differently from other types of investments. For example, if you just have two investments, big company stocks and bonds and you set them to be 50% of each (example only), if stocks do better than bonds as they normally do, you will have more than 50% of your portfolio in stocks. Your portfolio is now more risky. Or, if stocks do poorly, then you will have less than half your money in stocks, so your portfolio won't have enough risk to meet your goals. Putting bands around the targets tells us when we should rebalance.
Rebalancing is when we sell the investments that have done well and buy some of investments that have done poorly. This is hard to do, because it is the opposite of what our gut wants us to do. We have to sell the winners and buy the dogs. But by using this disciplined approach, we can consistently buy low and sell high...like we're supposed to do...without making predictions about the future.
Action Items
So what do we actually do if the market crashes like so many of these articles are predicting? We remind ourselves why we invest, we remind ourselves this is a long term portfolio, and we buy some more stocks after they've gone on sale.
