Black Thursday. Black Tuesday. The Dot-Com Bubble Crash. Each of these dates signifies the end of bull markets and a stock market crash. When a bull market ends, a bear market begins. But opportunity remains. Read on to learn how to take advantage of a stock market crash.
A bear market often indicates a recession, when the economy shrinks, people spend less, and unemployment rises. The good news is that they usually last no more than several months to 2 years, with the latest one lasting only 2 months — albeit with the aid of government stimulus. Though not every bear market means a recession is coming, the two often come together. Stock market crashes are the most dramatic indicator of a bear market and the shock of it causes many investors to panic sell and take large losses.
As of this article’s writing, global uncertainty, supply chain issues, and inflation have many anticipating a recession on the horizon so it helps to be informed and prepared to shift your strategy.
- The stock market is forward-looking so crashes are often indicators of negative economic events such as bear markets or impending recessions that make unemployment go up.
- Taking advantage of a down market through various strategies such as dollar-cost averaging or rotating into other sectors or asset classes will help you make the most of this massive discount.
- Build your investing system and strategy to guide your investing process and manage your risk reducing the sway of emotions in your process.
- People with no strategy or risk management are more susceptible to impulsive choices that can lose them money in any market environment.
Setting the Stage
First, let’s explore some useful terms and see how they are related to economic indicators.
If the stock market drops 20% or more, economic forecasts look lackluster, and investors feel negative, then all the markers of a bear market are present. As investors are forward-looking, their expectations of future growth and returns keep them invested and are the primary driver of the market cycle. If they see signals that significantly challenge those expectations, they will sell off their holdings and cause an avalanche of falling stock prices.
The price decline must last for some time, at least a few months consecutively. Bear market conditions can also apply to specific asset classes or sectors, such as gold from 2012-to 2019 as exemplified by the IAU gold ETF performance.
The switch from bull to bear is often cyclical and signals a recession.
If the economy has a widespread, large decline in activity lasting several months, then it is in recession. This decline is reflected in other indicators such as rising unemployment, falling purchasing power, and a reduction in retail purchases. An organization of economic advisers, the National Bureau of Economic Research (NBER) is responsible for declaring a recession.
A recession can be caused by any number of factors, but comes down to real changes or shifts in the economies, like the massive spike in oil prices or pandemic we are experiencing. A single recession can last for weeks, months, or years largely depending on how fast the economy adapts. No matter what causes them, they have real effects such as a stock market crash.
Stock Market Crash
It is a sudden and sharp fall in stock prices due to an unforeseen event, like a pandemic or natural catastrophe. Normally, when news comes out investors form expectations and price that information into the market. When significant, unexpected news breaks investors panic sell their assets, causing a cascade of sell orders rapidly leading to a stock market crash.
The most recent example is when the S&P 500 fell by about 30% in the first month of the pandemic, as seen below. But it rebounded sharply after making it the shortest stock market crash on record.
For those prepared, they were able to take advantage of the sudden crash and buy into the market at a steep discount. For those that sold and waited for another bottom, they missed the boat. Keep this example in mind as we go forward.
Here’s a how-to on coming out on top while the charts bleed red.
How To Take Advantage of Stock Market Crash
1. Build & Use Your Cash Position
To make the most of a crash, save up and have cash on hand. Having a cash position in your portfolio allows you to be a hawk and buy up your desired assets at the best prices. The cash in your checking account works but storing that money in a high yield savings account or moving it onto your brokerage will help separate it from your regular uses. It is also worth selling off a bit of your winning stocks and using the proceeds to buy into those on a discount.
Some experts recommend having a cash position of 5%, while others recommend 15 to 20%. It depends on your goals, as staying in cash incurs an opportunity cost. Currently, I am 10% in cash due to market volatility and working on my strategy for what to invest in.
2. Grow Your Tax-Advantaged Accounts
When stocks are on discount, it’s an excellent time to buy more for your 401(k) or IRA, if you can spare the cash. You can up your contribution rate on your 401k or deposit more money in your IRA to buy more. Even if you increase your contributions for a short amount of time, you can take advantage of the down market. You’ll bring homeless in the short run, so be sure you can take the hit.
The results will be best if your invest those contributions into a diversified index or mutual fund, such as VTSAX, to make the most return and save you time. Other mutual fund options may have higher expense fees and less long-term growth performance.
You can also rollover your 401k to a rollover IRA to unlock more investment options and have more control — if you have one from a leftover job. I rolled over my Roth 401k from my prior employer and have been able to invest in companies I believe in and bring more flexibility and customization to my portfolio.
3. Tax-Loss Harvesting
If you’ve got assets in the red, you can sell them off for up to $3,000 in tax deductions. Each year you can claim up to $3,000 in investment losses to deduct against your income on your tax return. If you have more than $3,000 in realized losses, you can carry over up to $3,000 of the excess portion to next year’s tax filing and continue to carry over the rest in a similar fashion. Though, this isn’t recommended unless you have a large outstanding tax balance or high income to pay down that warrants realizing a loss.
A loss isn’t realized until you sell off the asset. Realizing a loss helps offset your current tax bill but may harm your long-term investment goals. Consult with a tax advisor to determine if this strategy makes sense for you.
4. Stay in the Game
If you’ve already set your investing goals and strategy and thought about a down market, then think twice before changing them significantly. When the markets crashed in 2020, I held onto my assets which were mainly passive investing-based. I continued to contribute and held onto my assets and started to buy more on the upswing. If I had sold out completely when the market crashed and waited until it “felt right” to invest again, I would have hurt my long-term investing position.
5. Rotate Stocks and Asset Classes
When things switch from bull to bear, you shift your portfolio from growth to stability. In the last bull market, growth stocks like Tesla, Google, Amazon, etc. did very well as investors focused on future profits. In a bear market, investors focus on profit opportunities closer to the present and favor sectors such as Consumer Staples, Utilities, or Healthcare that are more “bread-and-butter.” People need electricity and shampoo, not the latest Tesla model. To ride the sector shift, requires some timing to maximize the return potential.
With this change in focus, people also shift to dividend investing. Companies that distribute dividends tend to be mature and have more stable stock prices, offering another source of return. Their maturity makes them more resilient and favored in a down market. Note the higher the dividend yield, the more risk the company bears. Coca-Cola (KO) pays 2.71% and Apple pays 0.53% while VOC Energy Trust (VOC) yields 12.84%.
In the past, I built a dividend stock portfolio by researching the Dividend Aristocrats, a collection of the “best” S&P 500 stocks with long histories of dividend increases. I bought several of the leading names and had a solid portfolio going, but returned to growth stocks as the bull market resumed.
You can also rotate your asset allocation into other asset classes that do well in a stock market crash or bear markets such as commodities, bonds, or real estate. Due to the recent price surge in commodities, I bought into US Commodity Index Fund (USCI) to diversify away from falling stock prices. Supply chain and geopolitical issues are making necessary commodities like grain, gas, and oil scarcer, driving up the value of accessible supplies and tamping down the value of companies that depend on these inputs.
As bonds are less risky than stocks, they offer lower returns but can be safe harbors to preserve wealth. Real estate is a safe asset class as people will always need shelter and you can always rent out a property. As its more conservative, it will take longer for the asset class to decline depending on the size and duration of a stock market crash.
You can get real estate exposure through a specialized service like Fundrise or buy into a real estate ETF like VNQ.
6. Dollar Cost Averaging DCA
This strategy is one of the best for investing as you consistently contribute in good and bad times. With dollar-cost averaging, you buy a set dollar amount into your portfolio at a regular interval (e.g. weekly, monthly). This strategy is the epitome of keep calm and carry on. Whether the market is in turmoil or not, DCA is the safest way to go and the most successful investing strategy next to perfectly timing the market. I DCA to build my passive investing portfolio — as this approach is great for ETFs, mutual funds, and stocks you believe in.
DCA is meant for both buying and selling. For instance, you can sell a certain percentage of your assets regularly when necessary, such as with the 4% rule for retirement. When you need to sell off your assets, using DCA decreases the ambiguity and guesswork of decision-making.
DCA evens out your average purchase price, even lowering it over the long-term. Buying in periodically reduces your investment risk as you don’t put in all of the investment amounts at one particular price level, especially if the asset is overvalued then. In this case, a stock market crash is an opportunity to buy more with the same amount.
7. Use Stop Loss Orders
Setup stop-loss orders on your assets to protect yourself from losing too much. Most brokers allow you to setup stop-loss orders such that if your stock declines below a certain price point, it will be sold off. These are used in volatile market conditions (or crypto markets) to minimize the potential loss. A stop-loss order sets a boundary on an investor’s risk tolerance and is a great tool to manage their risk, which we cover more below.
4 Things to Keep in Mind
Part of personal finance is risk management, meaning you balance the risk you take on against your expected return. It centers around preserving what you’ve already made. The essence of risk management is to create a system to remove the emotion and variability of human decision-making from the investing process.
You build up a stable foundation, outline your strategy, and write the rules for your personal system. Having a system setup provides a stable base before taking moonshots. I’ve included some of the concepts and tactics I use to manage my risk and investing process.
1. Timing the Market
Timing the market can be a fool’s errand — it’s unpredictable. No person or financial institution has a perfect track record in predicting the stock market’s moves. Successfully timing the market means you have to be right twice — when you buy and when you sell. Even if you make it work once, there’s no guarantee you can make it work consistently.
When I first got into crypto, I tracked the price of a bitcoin-linked asset for 3 days and tripled my money. I felt like a genius but could not predict it when bitcoin crashed less than a year later. I was caught holding the bag on some smaller, more volatile cryptocurrencies and learned my lesson the hard way as I saw them trend downwards. Many of those coins are no longer active projects today. Today, I am mostly a long-term investor as I buy and hold assets I believe will do well in the future. My passive investing base is made up of mutual funds and ETFs.
It’s much better to spend time in the market rather than timing the market. Spending all your time tracking and analyzing stock market movements and still getting it wrong can be very demoralizing and feel like a waste of your time. Who has the time anyways? Unless that’s your thing…
Your best bet to time the market is to do technical and fundamental analysis on your securities of interest and compare the results to your strategy to see if taking the opportunity makes sense for you. I watch investing content that includes technical analysis to help inform my views, especially in the fast-paced cryptocurrency markets.
2. Security in Hard Times — Risk Management
Stock market crashes have real impacts on people’s financial security, especially those approaching or who are in retirement. This is where risk management comes into play.
Whether the market is bear or bull, you should have a sizable emergency fund that grows with you throughout life and accounts for your financial obligations. As you get older, it should cover at least a year’s worth of basic expenses — maybe even 2 years’ worth. Someone with an emergency account is more likely to be unfazed in the face of a bear market or extreme market volatility.
The other tactic is to develop a diversified portfolio and rebalance your asset allocation such that it reflects your timeline to retirement and changing risk tolerance.
Before I started investing, I built up an emergency account to cover my expenses for 3 months, then 6 months. In the market crash of 2020, I felt secure with the savings I had accumulated. As I am a young investor, my portfolio is aggressive with a sizable allocation in growth stocks and cryptocurrencies. But it is based on passive index fund investing and my emergency account — giving me financial security and higher risk tolerance. As a result, I feel more empowered to pursue aggressive plays.
3. Pay Down High-Interest Debt
An economic downturn can lead to interest rate rises and credit becomes more difficult to come by. These conditions examine their financial security with a closer eye. If you have high-interest debt such as outstanding credit card balances, debt may become more expensive. It makes sense to allocate more money and focus on paying off this debt — even if you reduce investing contributions for a while. Credit card debt can grow at 15% 30% a year, exceeding any stock market returns.
Plus, the peace of mind you get from paying off your debt has a value all its own and you become free to focus on other things.
4. Playing Within Your Risk Tolerance
Everyone has a specific willingness to risk a certain amount of money in the markets and interest in various assets such as crypto, stocks, or bonds. Understanding your risk tolerance informs your investing strategy and how aggressive it will be. Figuring out how you would behave in extreme market scenarios unlocks your understanding of your risk tolerance. You may be an investor who prefers slow growth with little risk to preserve wealth or be a growth-oriented investor willing to put up with volatility and long time periods to wait for larger payoffs.
As a more aggressive investor with individual equities and crypto, I like to stabilize my portfolio against volatility by holding total market index funds. Investing within my risk tolerance has made me less emotionally reactive to my investing process and made me comfortable with my overall strategy.
The Bottom Line
A crash is a huge opportunity to both make or loses money. An investor can make considerable gains from how they play the stock market at this time. We covered the circumstances around a bear market, stock market crash, and recession and how all three are connected. We also addressed several strategies to make the most of a crash and ways to manage the risk of your investments.
No matter which way the market goes, it’s important to look at the data before you, develop your financial base, and adhere to your investing system to remove emotional turbulence from your decision-making. A down market or recession often arises due to a crisis but presents a great opportunity to take advantage of. We hope our tips help you make the most of one.
Frequently Asked Questions (FAQs)
Where should I store my money in anticipation of a market crash?
You can store your money in a checking or savings account, preferably a high-yield savings account with an online bank to capture the most interest. You can also use a money market or buy into a Treasury bond.
Should you stay in cash during a recession?
Yes. you should stay in cash to ensure you have an emergency fund that can last you 3 to 6 months. Then, you can use your remaining cash to invest in the market at discounted prices.
What is the safest asset to own?
The lowest risk assets include gold, money market funds, cash savings, and US Treasury notes. US Treasury notes are considered among the safest assets, often called “risk-free” assets.
Can banks take your money in a recession?
If your bank is insured by the Federal Deposit Insurance Corporation (FDIC), then your money is protected. The FDIC was created in 1933 to prevent “bank runs” when people would run to a bank to withdraw their cash.