What to do When the Stock Market Crashes

The Dow Jones Industrial Average index hit 17, 000 in the last week — a new record — and the S&P 500 Index followed suit. As is usual any time a stock market record is reached, the boo-birds make their appearance. “This is it!” they cry. “This is too high; a crash has to follow.” Well, something like that.

Of course, the boo-birds are right about one thing: The market always falls after it reaches a record high. The only problem is the market doesn’t drop immediately after each new record is set. It keeps going up … till it eventually does fall.

It always does. The history of the economy and the stock market are replete with cycles of booms and crashes. If you want to see a chart of the economy, you can click this link. The stock market cycles have the same wavy appearance. Both have the ups and downs we’ve become accustomed to, at least intellectually.

Why do you care about the stock market, especially if you are not a stock trader or investor? Most Americans’ retirement funds, be they in pension funds, 401(k) plans or IRAs of various descriptions, are tied up in stocks, directly or indirectly. You may remember how the Great Recession impacted those quarterly statements you received in the mail. So, whether you are active in the stock market or not, chances are it affects your wealth.

What do you do?

In general, there are two broad answers, depending on how close you are to retirement. If you look at the stock index chart in the link above, you’ll notice the time between peaks (and valleys) usually is around ten years. That means if you hang around and do nothing for ten years, more or less, you’ll find yourself having recovered all of the losses a crash would have inflicted on you.

That makes ten years a good cut-off point when considering your options:

More than ten years from retirement

Do nothing. Well, not nothing. You actually keep on investing. Warren Buffett, the world’s most successful investor, loves the periods when the market is down, because he always buys. And when the market is down, all his purchases are bargains. If you look at it like that, it makes sense.

The problem is that it’s hard to look at it like that. Why? Because we’re psychologically wired to feel good — rich, even — when we see the value of our home and investments go up.

But you shouldn’t, for two reasons:

1. The gain in wealth is unrealized. That means it’s not cash in your hand. And, as we all know, what goes up can come down. The only value that matters is the price when you sell.

That often leads people to sell assets when their value has gone up, “to lock in the gain.” There’s a problem with that, though: What do you do with that gain you locked in? If you sell your home, you need to buy another one. If you sell your bonds and stocks, what do you do with the proceeds? Chances are you’re not going to blow it all on a cruise around the world or a long weekend in Las Vegas. You need to invest it somewhere else.

Therefore, there is nothing to feel good about when you hear the value of your home or investments went up, unless you have a better thing to invest it in if you sell.

2. It’s a temptation to waste money. So you feel rich when you see the value of your home and investments soaring. But your daily grind continues unchanged. That creates a tension within you: “How come I still have to grind my little behind off, day after day, putting up with all the crud at work when I’m getting rich on my investments?” Maybe your car is giving you trouble. Maybe your home appliances are beginning to cost money. Maybe your clothes just feel old and out of style. This tension between the unchanged daily grind and the reports telling you you’re getting rich has many faces.

But those faces usually all lead to the same temptation to spend money — buy a new car, a nicer home or new clothes, go on a shopping spree or a long-deserved vacation. That’s right. We start using the “deserved” word a lot more when we see our net worth going up. (Funny, that in a recession, we don’t feel we deserve anything and we’re happy just to keep our jobs, or get one if we got laid off.)

The bottom line is that, unless you plan to retire in the next few years, just keep on going on with your investing. If anything, try to invest more when prices drop.

Less than ten years from retirement

This gets a little trickier, because the odds are that the stock market will not have recovered by the time you retire.

However, if you think about it, what are the chances you’re going to liquidate your entire life’s savings the very day you retire? Small, I’ll bet. You will be much more concerned with the monthly cash flow to cover your expenses. That means dividends and interest.

If dividends are your main interest, you are (again) unconcerned with the movement of the stock market. If, for instance, you have invested in Dividend Aristocrats, your monthly income is safe. It doesn’t matter if the stock market drops because those are stocks which have paid increasing dividends for more than 25 years. In other words, they have proven their stability by paying growing dividends through at least two prior recessions.

In other words, if you are getting close to retirement, the focus of your investments should be shifting to stocks (and other investments) which will provide you with the monthly cash to meet your needs.

And, if you do that right, you won’t have to worry about the stock market dropping.

We know the next stock market crash is coming soon. Just how soon, nobody knows. But, whether you’re retiring soon or are still a ways away, there is no need to panic when that happens.

3 Responses to “What to do When the Stock Market Crashes”

  1. Anonymous

    I have a long time until I need my money so I couldn’t care less about whether the stock market is booming or crashing. I just have my monthly investment set up to keep buying and I tune out all of the doom and gloom the television and newspapers are preaching. The more you can get your emotions out of investing, the better off you will be. But as you said, this is easier said than done.

  2. Anonymous

    Periodic rebalancing is a good idea, too. When the market correction comes (and it will eventually come), rebalancing will mean selling better performing assets (like bonds in that situation) and buy stocks when they are on sale.

  3. Anonymous

    When the stock market is about to crash I will buy some SPY Put Options and profit from the fall as well as protect my current portfolio. Also when stocks hit rock bottom it’s time to go shopping to buy stocks at really low prices.

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