Okay. It's a down market. What now? You've made savvy financial decisions up until now. You've saved. You've invested. You've planned for the long term. But what do you do when the market is going down and your heart is going up; pounding, racing, wondering when we'll hit rock bottom? How close to zero can we go before the world recovers? Will it ever recover?
Market corrections, recessions, bear markets, and nightmare-inducing crashes - are things we will all experience if we are in the market long enough.
So, how do we survive a crash? And more importantly - how do we thrive? How do we profit? Market crashes are how millionaires are made, it can turn millionaires into billionaires... it is what separates the men from the boys.
As Warren Buffett says, "A rising tide lifts all ships, it is only when it goes out that we get to see who was swimming with trunks."
In business, we use a tool called "SWOT" analysis. It stands for "Strengths, Weaknesses, Opportunities, and Threats." It is an okay business tool, but it is a great investment tool. Since we are in a down market and every second matters, we are going to change up the order. We are going to first look at the Threats and Weaknesses. In doing so, we will learn about our Strengths, and then we will identify opportunities for profit.
#1: No Quick Decisions!
The hardest thing to do in a down market is to not panic, making quick decisions that cannot be easily undone. As I said before, a market crash is when millionaires are made. And they don't become millionaires by panicking and selling near or at the bottom of the market.
Historically, markets don't crash in a single day. They slowly lose value over a period of time. Whatever is happening, you have time to make thoughtful choices...and, if the market is really moving quickly, then it is already too late.
By the time you, as a retail investor, place a market order, the price will have already moved and your loss will be greater. Institutional investors have the ability to shop around their trades and get best-pricing, so that they don't get slaughtered in a fast-moving market.
#2: Take Inventory
As a retail investor, there is only so much that you can do. You do not have access to advanced tools and information - nor do you have the time and resources necessary to manage investments on your own. So, what we want to do here is take an inventory of your portfolio and figure out where we are exposed - and what we can do about it.
For example, let's say you have a mutual fund from Fidelity that is invested in Emerging Markets. You check your online holdings and see that this fund has lost 30%. Your heart jumps into your throat - but wait a minute! This is just one investment within an entire portfolio. Maybe you have assets that are taking a beating, but your overall portfolio may still be ahead of the game.
So, let's take inventory. List out your entire balance sheet. This means ALL your assets, including your home, car, bank accounts, retirement accounts, etc...
#3: Rate Your Accounts:
When it comes to our life savings, we can't afford to make rash decisions. We need as much information as possible...and we need it to be easily recognizable information, numbers that we can quickly look at about which we can make quick decisions.
So, how do we do that? We rate our accounts. We assign them a risk score. Grade them based on HOW much risk there is of the account decreasing further!
#4: Rate Your Portfolio
Now that we have an idea of the risk we are facing, we are going to create a portfolio/household risk number. We do this by taking our current account value, dividing it by our total net worth, and then multiplying the result by your score. This will give us your weighted score.
#5: Determine Your Maximum Acceptable Loss
This is a hard question. We have to determine the maximum acceptable loss. This will be a function of several things:
Your Age: You are going to be more risk-averse the older you get because you have less time to rebuild your savings. If you lose 10% now, chances are it won't matter so much. But if that loss is 10 years from now, it will be harder to recover.
Your Income: The more money you make, the more you are able to recover from a loss - because you will have funds available for reinvestment.
Your Family Status: Are you married? With kids? This is another key factor in determining your risk tolerance. If you are responsible for supporting your family, you will require a greater cushion between what you have and the money coming in. It doesn't matter if that cushion is 10%, 20% or 30%; it makes sense to build a higher margin of safety.
Your Personal Situation: Do you own a business? Have a family trust or inheritance on the horizon? These things will increase your risk tolerance.
What is your personal risk tolerance? Here are some questions to ask yourself:
Take a few moments and define your fears. Is it that you are afraid of not being able to pay the mortgage, put food on the table? Is your fear that you won't be able to travel or see your grandkids in retirement?
For my dad, his fear was not having food in the refrigerator, so he was always stocking up. For my wife, it is about being without cash, so she hoards it in her savings account. Is either one the right financial move? No. But it makes them feel safe. Without a feeling of safety, we will be forever doomed to a life of anxiety, regret, and bad decisions.
For the specifics of how to go through this process, see my book Living with Financial Anxiety.
Once you know where your line in the sand is, the next question is how to protect it? At all times, we want to make sure that our emotional and financial bottom line is protected.
The second our bottom line is in danger, that is the moment when we start making bad financial decisions. Our judgment gets cloudy, we have trouble seeing the trees for the forest, our mind goes into survival mode, we get tunnel vision, and all we can think about is "how do we get out of this mess?"
So, protect your bottom line at all costs. It is okay to take short-term losses if it means that we can protect our larger pie.
#6: Risk Mitigation
Now that we know where to focus our efforts, the next question is what to do.
One way to reduce risk is to diversify our risk exposure.
The more we can spread our risk, the less of a beating we will take. The math is simple. While people may not spend money on luxury cars, they will always need to eat. This means that while one sector of the market (discretionary) will go down, other companies (such as utilities) will go up. Additionally, as people pull their money out of the market, there will be a "flight to safety." In this rush, those other asset classes and sectors will see a rise in value.
Diversifying across companies, sectors, asset classes, and countries allows us to better weather some of the market’s storms.
In diversifying our assets, we want to be strategic when making these moves. If we make them wholesale, we may lock in our losses. Something I like to do is triage my positions.
Positions that have fallen in line, or less than the broader market, can easily be swapped with their indices without fear. In essence, we are swapping the upside potential of that individual company for the safety and upside of the broader market.
Positions that have lost more than the market should be examined on an individual basis. A determination should be made about the fundamentals of the position, and whether there is still value in holding the position. In every market, there are winners and losers. There will be companies that go bust. While we do want to participate in the recovery of the market, we want to make sure that we aren't holding on to losers for sentimental reasons.
One of the best ways to profit from a down market is to tax-loss harvest. This is the process of selling positions that have lost money, in order to offset future capital gains. You then purchase similar, though not identical, securities.
For instance, if you own an S&P 500 ETF, you could sell it and buy an All-US Stock index fund. It's not the same, but it will have similar growth (maybe better, since it has small and mid-exposure which tend to do better.)
For more information see my full guide How to Survive and Thrive in a Downmarket
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