3 Steps to Prepare for a Market Crash

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I know this may come as a shocking revelation, but, yes, sometimes the stock market goes down. And every so often, it goes down really far, really fast.  Considering the current S&P 500 bull market is now the second-longest in history, it’s easy to understand why some have been lulled into an expectation of ever-upward stock prices.

Those following our other newsletters or commentary know my optimism about the longevity of our current state of market bliss is waning.  When, exactly, that tide will begin to shift is tough to say, but the reality we must all face is: This will not last forever.  So, while everyone still has what they came with, let’s talk about preparing for what may lie ahead.

After navigating two of the three worst crashes in the last 100 years, I’ve learned a few things about preparing for such events. I will share these insights here, with a sincere hope that you take this message to heart as there are few things worse than witnessing your life’s savings vaporize in a matter of months. And, please, don’t think it can’t happen to you, because it can and it will if you have not taken adequate precautions.

First, regardless of where we are in the economic cycle, everyone should know their “number.”  This term has made its rounds in the financial world over the last couple of decades, usually referring to the amount of money one must accumulate by a certain age to meet their retirement income objectives.  While that figure is important to know, it’s not the one I’m talking about.

For financial planners, the number that’s equally (if not more) important is a client’s required rate of return, or “required ROR.”  This not only tells us how much average annual interest the investor must generate to hit their savings objectives, but also helps us define the level of risk necessary to make it all happen.  Determining your required ROR can be tricky, but any competent financial planning professional will be able to calculate it for you.

If you already know your required ROR, give your advisor a high five!  However, simply being aware of the figure is not sufficient.  The key is ensuring your investment portfolio is structured in a way that makes the number relevant.  Here’s what I mean:

Too many times, we come across asset mixes that are either way too aggressive or not nearly aggressive enough to meet an individual’s objectives.  For example, we might establish a plan and discover someone (based on their age, rate of savings, and target asset level) only needs 3% average annual growth to achieve their long-term goals.  But when we look at their portfolio holdings, we find an ultra-aggressive blend of positions that exposes them to an unnecessarily high level of risk.

On the other hand, someone may have a required ROR of, say, 8%, but is invested in nothing but extremely low-risk assets like cash, CDs, and short-term debt instruments.  This scenario is particularly dangerous because, while believing they are “playing it safe,” the investor is actually condemning themselves to a situation in which they will never reach their savings goals.  At least, not without substantially altering their expectations.

So, Step One is:  Know your required ROR and adjust your portfolio accordingly.  I’d be willing to bet a lot of folks will find a big mismatch between the performance they need and the performance their portfolio is structured to achieve.

Step Two Is:  Reevaluate your risk tolerance.  If you have not read my blog post titled Risk Relativity, I encourage you to do so. The premise of the article is that, over time, investors have a tendency to experience a “drift” in the perception of how much market volatility they can handle before losing their cool.  In other words, one’s tolerance for risk is not static.  From my observations, the longer a bull market lasts, particularly one without any substantial dips along the way, the more (and larger) swings in account value an individual believes they can withstand before pulling the eject lever.

I’ve been at this long enough to understand some people really do have ice in their veins and won’t bat an eye at a severe, prolonged market downturn.  But I’ve also witnessed countless investors overestimate their fortitude during the good times, only to discover their true limits at the worst possible moments.  Succumbing to impulsive, emotion-driven decisions at the wrong time is the kiss of death in the investment world, so I encourage you do a little soul-searching now, while the sun is still shining.

If you believe you are an aggressive investor, I want you to try this mental exercise:  Allow your mind to drift from visions of prosperity and boundless wealth for just a moment and envision yourself in the depths of another 2008-like recession.  Imagine opening that statement to discover your account is worth just 40% of what it was a 12 months ago … still feeling like you want to swing for the fences?  You must understand that if you presume a high tolerance for risk, and invest accordingly, this is what you are signing up for, and you should be prepared to experience the potentially extreme losses that come along with it.  If, on the other hand, thoughts of a scenario like that make your palms sweat, now is a good time to rethink your risk tolerance and make any necessary changes to your portfolio.

My last bit of crash preparedness advice doesn’t have anything to do with investing but is no less important.  Step Three is:  Reduce your debt exposure.  This is a prudent move for anyone in any economic environment, but even more so if trouble is on the horizon.

The dynamics of a severe market contraction are complex and far-reaching.  A decline in equity prices is usually the starting point, with many other segments of the economy becoming collateral damage as the shockwave spreads over time.  As business slows and corporate earnings fall, unemployment will rise as companies begin cutting costs to survive.  Not surprisingly, people without a job don’t spend much on anything but the absolute essentials as they too attempt to weather the storm.  Fewer people spending money means even lower corporate profits and the economy goes into a self-reinforcing downward spiral until it finally reaches equilibrium, at which point the recovery and rebuilding process can begin.

So how does personal debt play into this scenario?  If you are one of the unfortunate many who may be out of work for a sustained period of time, the last thing you need is a mountain of debt payments every month.  Additionally, you may even need to tap into available lines of credit to survive.  With no liquid cash and all avenues of credit exhausted, many will be forced to sell their already depressed equity positions in retirement savings accounts.  That’s another scenario you want to try to avoid at all costs (pardon the pun).  At the end of the day, even if the world never experiences another financial crisis, carrying excessive debt is rarely a good thing.

There are many other facets of crash-proofing your personal finances, but, hopefully, this article will get you thinking in the right direction.  If nothing else, attempt to fully understand your present circumstances. Otherwise, you may find yourself among the millions of Americans who may be doomed to learning the hard way … again.  Unfortunately, along with that painful lesson comes a tuition bill many will never be able to repay.

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