Are You Certain a Stock Market Crash is Coming?

You should be honest with yourself: are you certain that you know when a stock market crash is coming?

Equity falls by 50%-ish about every decade, so it is certain that equity will crash at some point, but nobody knows when that will be. 

You can see from the graph below of the S&P 500 that there have been many periods where there have been sharp falls of about 50%. As this is a log plot the falls in the graph may not look as dramatic as the 50% they represent.

If you are honest and admit that you don’t know when the market will crash, then you probably should do nothing. If you have an investment plan, then stick with it!

If you own equity you need to be prepared to lose money, at least on paper, every so often. But remember equities drift upwards over time, so if you can’t stomach a short term loss, then it probably means you have too much equity/risk in your portfolio.

Log plot of the movement in price of the S&P 500 since 1962

How Do I Know If My Portfolio is Too Risky?

Equity has the potential to produce higher returns than safe-haven assets such as government bonds. But be aware that with high returns can also come risk. 

Even though the yields for government bonds are currently low, a portfolio made up of 100% equity would carry considerable risk, if you didn't have a long investment horizon. Bonds can add diversity to a portfolio, they are not correlated with equity and are less likely to crash at the same time. 

We all have different risk tolerance levels and some of this is based on personality. But there are definitely practical things you need to consider before you decide what to invest in.

These include things like how much time you have until retirement and when you expect to start using the funds.

A diversified portfolio is essential, and in practice it means splitting your portfolio into assets that are not driven by the same factors. 

Understanding your investment goals and risk capacity are important factors of choosing what to invest in and we cover this in our course: How to Create Your Own Cheap Robo Fund.

Just after the last crash in March 2020, I spoke to quite a few PensionCraft members who told me that they had sold off their equity in the crash despite knowing they shouldn’t have done it. 

The natural reaction if you hold too much equity is to panic when it seems like your wealth is disappearing, even if it’s only temporarily. The fact they sold told me that they were holding too much equity/risk as they couldn’t stomach the volatility in the market.

On the subject of risk, there is a relevant story that was related by Jesse Livermore, The Bear of Wall Street. It’s about the man who was so nervous that a friend asked him what the matter was.

I can't sleep," answered the nervous one

"Why not?" asked the friend.

"I am carrying so much cotton that I can't sleep thinking about it. It is wearing me out. What can I do?"

"Sell down to the sleeping point," answered the friend.

picture of a tired stick man

And keeping your equity allocation at sleeping point is what you need to do if you don’t want to end up selling in a crash.

How To De-Risk Your Portfolio

If you really knew a crash is coming, or simply if you deside you want to de-risk your portfolio down to sleeping point, then you would move from risky assets (equity, credit, real estate) into safe havens (cash, gold, developed market government bonds)

The illustration below shows the split between safe(r) and risky(er) assets and my video that this came from, where I look in more detail at safe assets is How To Invest During A Recession
Risk and safe assets illustration

When to Sell - When To Buy

For the “selling plan” to outperform the “doing nothing plan”  then you have to sell just before the crash actually happens.

This is because equity drifts upwards over time and you’ll miss out by reducing your equity exposure if you are wrong and they don’t sell off. 

After that, even if you choose your selling point exactly at the right time, you still then have to time your reentry into the market just right. You need to buy at a price that is lower than your original selling price. 

Markets can see-saw around and it’s easy to get caught up in the emotion and buy when its too high immediately losing you money. Or the market may bounce back and move quicker than you before you have a chance to buy. 

If you look at the performance of investors, many people underperform the index they invest in because they try to time markets, so the biggest risk for index investors is their own behaviour.

The global equity market has always recovered from crashes in the past this is why doing nothing is usually the best thing to do.

Graph of stock market volatility experienced in March 2020

Bad Reasons to Sell

If you are tempted to sell make sure it's not just for one of these reasons:

  1. 1
    Equity prices are at an all-time record (this is the usual state of affairs because equity prices drift upwards!)
  2. 2
    You read a news story that told you to sell
  3. 3
    Your friends or colleagues at work are selling
  4. 4
    You don’t think equity can go any higher because prices have increased a lot recently

Good Reasons to Sell

There aren’t many good reasons to sell if you are an index investor the normal state should be buy and hold but good reasons may be:

  1. 1
    You need the money e.g. your pension is in drawdown
  2. 2
    Your circumstances have changed, perhaps your investment horizon is forced to be shorter by some life event which requires a reduction in your share allocation 
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