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Four Ways To Protect Your Stock Portfolio For The Upcoming Market Crash
Updated: Aug 17, 2022
At the time of this writing, social media, YouTube, and nearly all investment websites are predicting a recession sometime in the next 12 to 18 months.
From the escalating war between Russia and Ukraine, to the Federal Reserve increasingly raising interest rates and reducing its balance sheet in the midst of a lingering pandemic, among several other factors, there seems to be a lot of merit to these forecasts as inflation has skyrocketed to a 40-year high.
Recently, the US treasury long-term bond and short-term bond yield curve has inverted, which has preceded every recession since the 1950s. See the links below this article for more in-depth information about the recession and stock market crash fears.
Regardless of the timing of when a stock market crash or recession will occur, the truth is that given enough time, a market crash is inevitable. History has shown us that the stock market cannot go up forever and is doomed to periods of corrections where the stock market will decline by 10-20%. Thankfully less often, eventually there are catalysts which trigger full blown market crashes of more than 20%.
It's going to happen to long-term investors sooner or later, and we need to be prepared and have the right mindset when the crash hits. Below are four ways to protect your stock portfolio during the upcoming market crash:
Hold cash savings
Diversify your assets
Reallocate your stock portfolio
Do nothing
1. Hold Cash Savings
The simple truth is that during a recession or stock market crash, cash is king.
People who have large amounts of cash savings during these times have the ultimate form of protection because cash can create so much opportunity during hard and uncertain times.
At any time, it is not a bad idea to have 3-6 months of expenses saved as an emergency fund, and during a recession, the likelihood of someone being laid off from work or losing income is elevated. If you were to run into a financial emergency such as loss of work or income, then having a large amount of cash reserves would prevent you from selling your stocks at probably their lowest prices during a market crash creating large, permanent losses.
If you are fortunate enough to not experience any financial emergency during a market downturn, then holding cash gives you the ability to buy your favorite, highest conviction stocks or assets at bargain basement prices. Nobody can time the exact bottom of stock market prices during a crash; most likely, you will buy the dip and it will keep on dipping.
However, enough cash will give you the ability to hopefully dollar cost average by buying stocks in intervals over time throughout the crash for your average cost of the stocks in your portfolio to be the lowest possible for the inevitable stock market rebound or bull market.
Now more than ever, it's time for us to save and hold cash to pounce on the market crash to come.
2. Diversify Your Assets
If you have a feeling that a stock market crash or economic trouble is looming, then it is probably time to diversify your portfolio of assets to hedge against a stock market collapse.
When diversifying your assets, the goal is to have a pool of assets at any given time that are not correlated with one another. This is so that when the stock market crashes, hopefully the prices of some of your assets will go up while the prices of some of your other assets go down.
Precious metals: It's well known that precious metals such as gold and silver have an inverse relationship with the stock market. When the stock market dips, gold and silver prices tend to go up in value. Gold, especially, is seen as a safe haven asset that investors flock to when stocks plummet.
Bonds: US treasury bonds and some corporate bonds also tend to have the same inverse relationship; as stocks fall, you can expect your bonds to go up in value as well.
Cryptocurrency: Cryptocurrency is a wild card as there is not enough history to know how crypto will perform in a major stock market crash. However, in theory, the fundamentals of some cryptocurrency are not the same fundamentals that drive stock market prices.
Artwork: Another interesting idea is owning iconic pieces of artwork though sites such as marketworks.io (link below) as studies show that this asset class is weakly correlated with the stock market.
Real estate: Real estate is another asset class that is weakly correlated with the stock market in the sense that home prices will go down during a recession, but the real estate market cycles and the stock market cycles differ.
Check out the links below to understand more about assets with a low correlation to the stock market. A stock market crash can be unpredictable and happen in the blink of an eye, so when a crash does happen and you're not diversified in your assets, it will probably already be too late.
The goal is to always have about 10-40% of our assets in these alternative asset classes uncorrelated with stocks, so when the stock market crash happens, hopefully it will mitigate our losses and smooth out the ride.
3. Reallocate Your Stock Portfolio
No matter how much conviction you have in a stock or company, the truth is that speculative, high growth stocks and equities will get hit first and hardest in a stock market crash.
When a crash happens, investors will tend to flock to what are considered safe, "risk off" assets. Stocks with high price-to-earnings ratios or price-to-sales ratios will suffer the worst during a market decline, so an investor wanting to preserve the value of their portfolio in the short- to medium-term might be wise to rotate out of these high growth, speculative stocks into more established, profitable companies.
To understand why these high growth stocks are crushed the most during hard times, you have to understand that high growth stocks are constantly investing capital back into the business to grow revenue and margins at the expense of profitability. During a recession, the cost to borrow is more expensive and raising capital is much harder and is considered a headwind to the growth of a company.
Economic activity, consumer spending, and the revenue of businesses obviously decline during a recession, so investors like to see that a company has lots of cash or cash equivalents on its balance sheet to survive market downturns, which is not always true for new, growing, or less established companies. The multiple that investors are willing to pay for the growth of a company as seen in the company's price-to-earnings ratio or price-to-sales ratio shrinks dramatically compared to a bull market as investors transition to a "risk off" environment.
Investors prefer companies that are profitable now and have the ability to continue making money even during a recession instead of the more speculative companies that might be profitable and successful someday, but that future profitability and growth are more uncertain due to recessionary headwinds.
If you believe that the stock market is going to take a turn for the worst, now might be the time to reallocate your portfolio into more blue-chip, established, profitable companies that will allow you to sleep better at night.
These stocks may fall in a crash, but will most certainly fall by much less percentage-wise than riskier stocks. Think stocks in the consumer staples category such as Proctor & Gamble, Target, and Dollar Tree that sell essential products and goods such as foods and beverages, household items, and toiletries that people will need to buy regardless of economic conditions.
Also think of mega market cap companies such as Apple, Amazon, Microsoft, and Google, which have products and services that people rely on and are integral to everyday life regardless of the stock market or economy.
Reliable stocks that pay a nice dividend yield may be your best friend as the dividend payments can provide income during uncertain times in the market and your life.
If you are a risk-adverse investor, then fears of a market crash may be the perfect time to take a hard look at your portfolio and go on the defensive by reallocating your portfolio away from the high growth, moonshot stocks.
Although some high growth companies might provide the most return in the long-term (Apple stock price was once $6 and in single digits during the dot.com bubble of the early 2000s), by holding these companies through a stock market crash, you must be willing to stomach the deep red in your portfolio or spend the money to continuously reduce your average cost as prices fall.
4. Do Nothing
Seriously, do absolutely nothing during a stock market crash. If you don't have extra cash on the side to buy stocks at a discount, haven't diversified your assets, or weren't quick enough to reallocate your portfolio, then doing nothing is probably the best thing you can do in moments of crisis.
If you have invested in truly great companies with terrific management and immense opportunities ahead of it, then the market crash will pass eventually, and the stock price will go on to reach new highs.
When in doubt, you should zoom out on the stock price chart for the entire history of any successful company that first comes to your mind or the S&P 500, and you'll see that over the decades, the periods of the worst stock market crashes are tiny blips on the chart, but the company or stock market has always recovered and kept reaching for record all-time highs given enough time.
See the link below to see for yourself how resilient the stock market is or how great companies provide stellar returns in the long-term. The worst thing you can do if all else fails is to sell your stock at their lowest prices due to emotion and fear. At this point, it's time to trust your conviction and research in the stocks you hold knowing that if your due diligence with your stocks is good, then there's a good chance you'll be happy that you held in five to ten years.
If you find yourself getting emotional and afraid watching your stock prices fall, I suggest deleting the investing apps on your phone and going weeks or months without looking at your portfolio; make a rule for yourself that you will only look at your portfolio after you get paid and you're ready to buy more of the discounted stocks in your portfolio or your watchlist.
The more you watch your portfolio everyday as it falls, the more likely you will make irrational, rash decisions out of emotion and succumb to capitulation. Invest for the long-term in great companies, and in the long-term, you will come out on top.
Stock Market Risks and Talks of Stock Market Crash Links:
Asset Correlations to Stock Market:
https://www.datadriveninvestor.com/2020/02/02/the-best-way-to-use-stock-market-correlations/
https://www.investopedia.com/articles/financial-theory/09/uncorrelated-assets-diversification.asp
Market.IO (Invest in Iconic Pieces of Art):
Market Prices Over Time:
https://www.wealthify.com/blog/a-history-of-market-crashes-and-how-they-recovered
https://analyzingalpha.com/blog/will-the-stock-market-always-recover
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