The market will crash again. That is inevitable. The only real question is when will it happen?
Let’s be clear: there are lots of reasons to believe the market could crash soon. Skyrocketing inflation , stretched valuations , and a critical labor shortage each could pose risks to the market on their own. Put them all together in a situation like we have today, and the danger certainly seems to multiply.
Just because the market could crash soon doesn’t mean it will, however. If it somehow manages to keep climbing, would you really want to be sitting on the sidelines, watching the purchasing power of your money evaporate to inflation?
That combination of factors makes now one of the toughest times in most of our investing lifetimes to know what the best course of action should be. That might actually mean that there is no single best path forward and that the right approach could be to build a balance across the five options discussed here.
No. 1: Get out of (expensive) debt
If the market’s massive run has left you in the position where you could pay off your debts, maybe that provides a good opportunity to actually do so. If not your entire debt burden, perhaps you could pay off everything but your fixed-rate, low interest mortgage?
It might seem crazy to pay off debt when interest rates are so low and the market has seen such huge recent rises, but that could very well be the best time to do so. After all, if interest rates rise, that could both increase your debt service costs and cause at least some of your stocks to drop, catching you with a double-whammy. When you add in the fact your debt service costs need to be paid even if your stocks are way down, you get a situation where reducing or eliminating debt looks like a smart move.
No. 2: Build a cash buffer
In a world where inflation is running over 6%, having a lot of cash sitting around earning less than 1% might seem crazy. When viewed only on that basis, it is. When you recognize that market crashes and job losses often go hand in hand, having a decent cash buffer can be viewed as an insurance policy. At least for a little while, it can keep you from being forced to sell at the low due to lost income and buy you time to find alternatives.
That said, with inflation running as hot as it is and cash returns failing to keep up, it might not be a good idea to hold too much cash. As a result, consider the standard guidance of three-to-six months’ worth of basic living expenses as a reasonable “goldilocks” target.
No. 3: Plan for the big expenses coming your way soon
As a general rule, money you expect to spend within the next five years does not belong in stocks. If you have a big purchase coming up in that time window — say a new car, a child’s college education, or a bucket list vacation — a market sitting near all-time highs can give you a great opportunity to sell.
It’s OK to sell enough stock to cover the costs of what you’re buying in that window and any taxes you’ll owe on your stock sale. Then, put the remaining money in something like a CD or Treasury or investment grade bonds that mature just before you’ll need the money.
No, you won’t make stupendously high returns on that money, but you will also sleep more soundly knowing that a mere market crash won’t automatically derail your near-term plans for that cash.
No. 4: Know a decent estimate of the value of what you own
Ultimately, stocks are nothing more than fractional ownership stakes in companies. Yes, their market prices can rise or fall a whole bunch in a very short period of time, but in the long run, stocks are tied to the cash generating capability of the businesses behind those shares.
Using the discounted cash flow model and reasonable projections for the future of the company, you can estimate what that fair value would be. You can easily adjust your assumptions for a more aggressive growth future or a more pessimistic one as well, to get a feel for a range of potential values. You can then compare your model with the market’s price and use that to inform your buy, sell, or hold decisions.
If a company you own is priced so high by the market that even your most aggressive estimates for its future can’t keep up, then it might be a good idea to sell it. On the flip side, if a company you own is available for such a dirt cheap price that even your pessimistic estimate is above the market’s price for it, you might want to consider buying even more.
The beauty of the discounted cash flow model is that it can help you make those buy/sell/hold decisions regardless of what the overall market is doing. As a result, it can help you both prepare for a crash by figuring out which companies to consider selling and invest through a crash by figuring out which ones are the biggest bargains worthy of buying.
No. 5: Invest with the long term in mind
With the first three options, you’ve taken great steps to protect yourself against many of the short term disruptions that can come from market crashes. With the fourth option, you’ve given yourself a tool to make smarter investing decisions around the time of a crash. Together, they free you up to truly have a long-term perspective when you invest in stocks.
That long-term perspective is important because it provides the foundation of the biggest advantage you have against Wall Street: your patience. With a long-term perspective, the rest of your financial house in order, and decent valuations at your disposal, you can stay invested during and after a crash. That is absolutely key to being invested during any subsequent recovery, which is where the next round of wealth can be built.
Get ready now for the next crash
None of us really know when the next stock market crash will happen, but we can be pretty sure that there will be another one headed our way. With the market near all-time highs and so many very clear economic risks in front of us, now could be a great time to make the adjustments you need to get prepared for that crash.
By balancing the tools you need to survive the next crash with a long term perspective for the money you’re able to keep invested, you can be prepared no matter when that crash takes place. Get yourself ready now, and you will have the advantage of being ready before it happens, rather than trying to clean up after the fact.
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