How to respond to a stock market crash

Rather than fleeing the stock market like a rat from a sinking ship, make sure the following things are in order.

By MSN Money Partner Aug 5, 2011 9:24AM

This post comes from partner blog The Dough Roller.

 

The absolute best time to go on vacation is during a stock market "correction." I'm sitting here in Phoenix trying to figure out how to survive 110-degree temperatures, so I have little time to worry about my portfolio. But it is hard to ignore what's going on in the market. Thursday the Dow tumbled more than 4%, and the Nasdaq fell more than 5%. Ouch!

 

So the question is how to respond. We know that many investors are fleeing the equity markets in favor of Treasurys. As reported by Reuters, U.S. Treasury debt prices soared (sending yields crashing) as investors fled equities. Should we do the same thing and sell our stocks and mutual funds and buy U.S. debt?

 

For me, the answer is absolutely not, and there are several reasons:

  • Timing the market. I'm always amused when some mutual fund manager is interviewed on TV, and his credentials are the fact that he "predicted" the stock market decline or the housing crash a few years ago. Experts are always predicting something, and some of them are bound to be right some of the time. But for market timing to work, you need to be right all of the time. Maybe you're that good; I'm not.
  • Investment horizon. I won't need my investments for at least 20 years. As a result, what the market does today, or this week, or this month, or even this year doesn't much matter. Of course, if you are about to retire or are in retirement, the current market may be very important to you. But if so, your asset allocation should reflect your financial needs such that more of your money is in income-producing investments, rather than equities.
  • U.S. Treasurys. Although U.S. Treasurys are still viewed as a safe investment, I think they are largely a terrible investment. Many one-month T-bills yield between 0.003% and negative 0.003%, according to The Wall Street Journal. And given our debt, deficits, and unwillingness to meaningfully address either, I don't see U.S. Treasurys as the sound investment they once were.

Here's the reality: The time to prepare for a stock market crash is before it happens. As investors, we should expect to see market corrections periodically. Just having that expectation is the first step in dealing with market declines like we saw Thursday. (In Scott Peck's words, life is tough. And as soon as we realize it's tough, it gets easier.) But the question remains, how should we prepare for the inevitable market declines? Post continues after video about Thursday's sell-off and today's jobs report.

Rather than fleeing the stock market like a rat from a sinking ship, I prefer to make sure the following things are in order:

 

Asset allocation. As I've written before, asset allocation is making sure you don't keep all your eggs in one basket. For most, asset allocation means investing in both stocks and bonds, and for each, both domestic and international offerings. An asset allocation plan can be a lot more complicated, but it need not be. The key is determining how much to put in stocks vs. bonds and domestic vs. international investments. Some time ago I wrote an Asset Allocation Guide that covers investment plans for all ages.

 

The proper asset allocation won't insulate investors from losses. But it should protect investors from unacceptable losses given their financial circumstances. And as important as an asset allocation plan is, don't forget to periodically rebalance your investments.

 

Emergency fund. It may seem odd to talk about an emergency fund in the context of a stock market dive, but they are related. The goal is to arrange your finances so that a steep sell-off in the market does not cause you to sell in panic. And a great way to keep your cool is to have a healthy emergency fund in a high-interest savings account. If you are using your investments in the stock market as your emergency fund, you are far more likely to sell when the market plunges.

 

Manageable debt. Managing debt is important for everybody, but it's particularly important as you near retirement. While you can't snap your fingers and get out of debt overnight, you can take meaningful steps to reduce your debt. By reducing your debt, you also reduce your monthly financial needs. And if you are relying on stock market investments to pay off debt, you're making a big mistake. The stock market should be seen as a long-term investment (10 years or more). For debt payments that need to be made now or in the near future, the money should either come from employment or, if you are in retirement, risk-free investments.

 

And if you manage your finances appropriately, you can even profit from a stock market crash.

 

As a parting thought, here is some Warren Buffett wisdom to see you through the market turmoil: "In the short run, the market is a voting machine, but in the long run it is a weighing machine."

 

More on The Dough Roller and MSN Money:

VIDEO ON MSN MONEY

1Comment
Aug 5, 2011 1:34PM
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Mr. Dough Roller...  there is no such thing as a high interest savings account.
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