Stock market crashes are incredibly difficult to predict, but there are signs to watch out for to better prepare for a stock market crash. Over the past few decades, investing in stocks has been quite profitable, but only if investors were diversified enough to withstand losses incurred by one or two of their high-risk investments.
Recently, the stock market has been hitting new all-time highs, and many people are starting to wonder when this party will end – because it always does. At the same time, no one can accurately predict when Wall Street will take its next big tumble. But some warning signs already indicate that the market is overheated and due for a correction.
In This Article
What causes market crashes?
A market crash is defined as a sudden fall in the price of stocks across a large section of the market within a short period of time.
The causes of a stock market crash can vary depending on the country and its economy. The reasons can also vary depending on the time period the crash occurred.
The most common causes of a stock market crash include, but are not limited to:
- Unsustainable economic growth or inflation
- Speculation on the part of investors
- Weak banking system
- Deregulation of markets leading to a lack of oversight
- Inadequate information from regulators or from those that have insider knowledge
How Do I Prepare for a Stock Market Crash in 2022?
Market crashes are not as rare as many people believe. In fact, there have been 26 bear markets since 1928. A bear market is defined as a 20% or more decline from a recent peak in the market.
Here are a few active steps you can take to prepare for a stock market crash in 2022.
1. Understand your investments
Assess your portfolio to make sure you understand your investments and have a good reason for owning them. Never buy a stock you don’t know just because someone else bought it or recommended it.
If you own individual stocks, ask yourself whether you understand the fundamentals of the underlying business:
- How does the company make money?
- What was so compelling about this stock that made me buy it?
- Are there any long-term opportunities in the company?
- Are the opportunities still available even during a market crash?
- Is the company’s business model robust?
- If there was a recession and people lost their jobs, would the company be able to continue to make money?
- How much debt has the company accumulated?
- Will the company be able to continue to pay its liabilities, or will it go bankrupt?
If you have solid answers for these questions and are 100% confident in the company and its leadership, you have no reason to worry. Keep holding the stock.
On the other hand, if you don’t have answers to the above questions or are not sure that the company’s fundamentals are strong enough to withstand a recession, you have no business having the stock in your portfolio.
2. Don’t Let Fear Make Your Decisions.
During a stock market crash, the worst thing you could do is make hasty decisions based on fear.
On the other hand, the best thing you can do is stay put and do nothing, at least for a while. It will help bring the emotions down, allow you to recollect your thoughts, and start making rational decisions based on what you know to be true about your investments.
Unfortunately, panic selling is the most common and probably most damaging reaction among investors.
3. Diversify Your Portfolio
Choose your investments wisely; diversification is key when it comes to ensuring your savings remain safe during a crash. Having a diverse portfolio minimizes risk while at the same time increasing potential earnings over time if managed correctly.
For example, if you had invested $25,000 in S&P 500 stocks with an average growth of 7% annually over the last forty years, your investment would have grown to 4.2 million dollars total. On the other hand, if you had invested that same amount into just one stock, and that company suddenly went bankrupt or failed to produce high enough returns on investments (ROI), your entire savings would be gone in a heartbeat.
4. Favor Index Funds
An index fund is a group of stocks that trades as a single security. An example of an index fund is the S&P 500 that consists of the largest 500 companies in the US stock market.
Investing in index funds is a great way to diversify your portfolio. It’s kinda like ‘diversification done for you’ type of investment.
The thing about investing in the largest 500 companies is that you don’t have to worry about a company going bankrupt. If one actually does go bankrupt, it would represent a loss of only 0.2% of your portfolio.
Unlike investing in a handful of individual stocks, where you’d lose a lot of money if one company goes bankrupt, investing in an index fund provides a good sense of security.
Index funds will also help you avoid many of the shocks that occur during a market crash and allow you to continue making investments without worrying about losing everything.
For example, if you have an index fund that invests in multiple companies, some of those companies might have a good year while others have a bad one. In this case, you will be able to ride out the bump.
In addition, index funds are ideal if you want an investment that’s a bit more hands-off but still grows steadily. You can just invest once and forget about it.
5. Carve Out Some Savings
Even after diversifying your portfolio, it’s essential to remember to save some money for a rainy day.
Having all your money in investment vehicles is dangerous. For instance, if a stock market crash coincides with an economic downturn, there’s a high risk of losing one’s job. And if you lose your job, you’d be forced to sell your stocks at a loss to cover your expenses.
Having an emergency fund will help you stay afloat until you get your next job. It will prevent you from having to sell your investments at a loss just so you can pay your bills.
Your emergency fund should contain at least six months’ worth of living expenses which can cover things like rent/mortgage, food, transport costs, etc.
Read More: How to Stop Living Paycheck to Paycheck
6. Keep Your Savings Liquid
This point is closely related to the previous sub-topic but will explain where to hold your savings.
Liquidity means being able to access your cash exactly when you need it. It, consequently, suggests that your emergency fund should be highly liquid so that you can access it immediately in the event of a crisis.
Locking away your money in investments that are difficult to sell would mean that you can’t access your cash if you encounter a job loss, illness, or a market crash.
The best place to have your savings is in a high-yield savings account. Such a savings account will pay you interest to hold your cash.
Other examples of liquid investments include:
- Checking account
- Short-term CDs (certificates of deposit)
- Government savings bonds, and
- Money market accounts.
Finally, don’t forget about inflation. Inflation is the gradual rise of prices for goods and services over a period of time that devalues your money. Accordingly, your savings should only consist of the funds sufficient to keep you afloat during an emergency and nothing more. Have the rest of your money invested in a solid portfolio that will grow above the inflation rate. Otherwise, inflation will eat up your money.
Read More: 3 Cheap Growth Stocks to Buy Now
And that’s exactly how to prepare for a stock market crash.
Using this information, you are now able to begin planning out your investment strategy for 2022 so that when the next crash happens, you are already ahead.
Remember to keep an eye out for the crash and have a strategy in place before it happens. Take some time to design long-term goals and plan out changes to your portfolio so that you are not caught off guard when it finally happens.