Actually, it is not so much a matter of what to do "if" the stock market crashes again as it is "when." The history of the U.S. stock market - really any market - is one of ups and downs. So what should you do when market downdrafts hit? Here are six tips to help carry you through to the next up move. (Learn more about market crash patterns in our Market Crashes Tutorial.)
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1. Be Prepared
Ideally, you should not wait for the market to decline before taking action. Instead, invest in a way that will allow you to persevere when it does retreat. That means diversifying your investments among different types of assets, including stocks, bonds, commodities, real estate and liquid investments. By spreading your investments around, and rebalancing regularly to ensure you remain diversified, you will find that your portfolio is less likely to suffer as much of a fall as the stock market alone.
In fact, as some of the assets fall, other assets may actually rise - or at least fall less - trimming your potential paper loss. Think of diversification as the safety net below the high wire act. It does not prevent the fall. But, the net helps ensure all will not be lost.
2. Know the Warning Signs
Let's face it, crashes typically do not occur out of nowhere. There are often warning shots - big down days that are quickly written off as "corrections." But whether a sudden downdraft is a blip during a bull market or a sign of a direction change use it to your advantage. Take a clue from how your securities behaved to determine whether or not your portfolio is carrying too much risk. Then, if necessary, make adjustments.
For instance, reduce your stock exposure by trimming back some of your larger positions - not necessarily selling outright, just trimming a 200 share position to 100 shares - and investing in something more defensive, a security that either didn't decline as much or didn't decline at all in the sell-off. That way, you are better prepared for the next down day, but still in a position to profit as you originally planned if the sell-off was in fact a blip. (Learn more about spotting real emergencies, read Spotting Companies In Financial Distress.)
3. What to Do on the Way Down
Take a deep breath. Stay calm and carry on. Remind yourself why you are invested (hint: for the long-run is the "A" answer). The savings you commit to stocks - or any other investment that can crash - should never include the money you need to feed your family next week, or even to pay the tax bill in three months. It is money invested for the long-term. Why? Because only over time can you expect to benefit from investing. Also, it means you don't have to sell at depressed prices. You can afford to be patient and wait out the storm. When you finish taking your deep breath, pull out a chart of the market. Why? It will remind you that over time markets have done well for their investors.
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4. Don't Try to Catch a Falling Knife
As markets decline, it is only natural to try to call the bottom and "buy the dips." That can be a valid and profitable strategy. In fact, doubling up on a fallen asset - buying more and lowering your cost basis - means that if/when that issue recovers, you will get back to breakeven much faster and may actually make a profit before the asset's price ever returns to your original purchase price. But even when experts do this, they avoid doing it too soon – like on the first down day. When a market is in a freefall, it is best to just stay out of its way, whether you are buying or selling. Let it fall, then pick up the pieces once the dust settles. (For more, check out 4 Tips For Buying Stocks In A Recession.)
5. Be Opportunistic, Not Optimistic
As the dust settles, look through your portfolio with a critical eye. "Good" issues fall with the bad. That creates an opportunity to improve the quality of your portfolio holdings, by buying stronger, higher-quality competitors to the stocks you own, and buying them at an outrageously discounted price. The competitor's stock is likely to rise more quickly in the bounce back. To do this, you need to see your securities as currency - do not think about where they once traded, but rather ask: can I find a stronger "horse" for these dollars to ride on the way back up?
When the market falls, the media coverage can turn into a full-blown frenzy. The intensity can cause even the most well-diversified, well-prepared investor to experience fear and self-loathing. At that point, step away from the TV and computer, and go see a movie. The worst thing you can do when the market is falling is to let your investment decisions be driven by panic.
Catch up on your financial news; read Water Cooler Finance: The New iPod And The Roller Coaster Market.