3 reasons not to worry about a stock market crash
With the stock market officially in bear territory, it’s natural to wonder how bad things could get before we hit bottom. Indeed, while 2022 has been tough for the stock market, so far this year the worst day in the S&P500 has been only a decrease of 4%. It’s not even enough to trip the market “circuit breakers” and put a temporary pause on trading. Although the decline was painful, it was not a rapid market crash, with all the instant wealth destruction that entails.
In other words, the situation could get even worse if the market crashes outright from these levels. Despite this nasty potential, there are at least three reasons not to worry about a stock market crash, as long as you’re prepared for one.
1. You have a decent hard cash emergency fund
Although inflation eats away at the purchasing power of your money, the reality is that a stock market crash can destroy far more value in a day than even currently high rates of inflation can destroy in a year. In addition, severe stock market crashes often lead to heavy job losses.
If you lose your job during or just after a stock market crash, or if you face a crisis while the market is down, an emergency fund can provide you with a much-needed buffer. A reasonably sized emergency fund — about three to six months worth of expenses — won’t keep you afloat forever, but it will buy you some much-needed time.
This cushion can prevent you from having to sell your shares in the middle of a very coarse market. After all, your bills don’t stop coming just because the market is down or you’ve lost your job. Not being forced to sell stocks near their lows, thanks to an emergency fund, can make all the difference in being able to participate in any subsequent market rally.
2. You don’t need to sell your stocks to cover your short-term costs
If 2022 did anything useful for investors, it reminded us that stocks can go down as well as up. That’s why the money you’ll have to spend over the next five years doesn’t belong in stocks.
Instead, the money you know you’ll need to spend in that time frame should be cash, CDs, or high-quality, duration-matched assets, such as high-quality Treasury bonds. To be clear, you won’t win a lot on these types of investments, but there’s a much better chance that the money will be there when you need it. Much like an emergency fund, these assets can save you from having to sell when the market is down just to cover your costs.
The other advantage this approach gives you is that it will long way to help you stay alert when the market crashes. To support the long-term thinking needed to stay invested while stocks are falling, there’s nothing like knowledge you don’t need to spend the money you invested in stocks over the next few years.
3. You don’t use the margin to invest
As long as you’re not using margin to invest, just because stock prices are falling quickly won’t force you to sell your positions. If you use margin, however, falling stock prices can trigger a margin call, which could force you to sell while your positions are falling.
When a margin call occurs, your broker can liquidate any position in your account. In a margin call, your broker doesn’t care about the long-term prospects of your investment, whether you face a capital gain or loss, or anything else of value to you. All the broker cares about is closing the call and eliminating your obligation. Therefore, a forced liquidation by a broker could not only prevent you from participating in any subsequent takeover, but could also lead to unpleasant tax consequences.
Margin really is a double-edged sword, and it’s also a tool your broker uses to stack the odds in their favor. Not only does your broker earn interest when you take out a margin loan, but that broker can also change the terms of the margin agreement. Often, this involves setting stricter terms after a stock falls, which can force a margin call or make an existing margin call worse. It’s tempting to use margin in a rising market, but when (not if) the market is falling, your losses can easily more than offset the gains.
put it all together
If these three statements currently apply to you, you will find it much easier to ride out a stock market crash; indeed, you might even take advantage of a market crash to buy big companies at low prices. If, on the other hand, you miss one or more of them, there’s no better time than the present to prepare.
Whether or not the market plunges soon, the reality is that it will crash again at some point. By preparing yourself before it happens, you will be in a much better situation than if it happened before you were ready. So put your plans in place today and you may be able to significantly reduce your worries about the state of the market.