This guide will help you stop panicking about the next stock market crash.
Stock market crashes are expected, but completely unpredictable. Historically, a stock market correction (falling 10% or more) occurs about once every 1.8 years. While we know for sure that another correction is inevitable, we have no idea when exactly it will happen.
Fortunately, you can prepare for this kind of falls in advance (as they say – spread straws). Here are five ways to protect your finances (and even multiply them somewhat) during the next downturn in the stock market.
Step 1: For every 5% drop in the S&P 500, invest an additional amount of money
Of course, it is unpleasant to watch how the value of your investment portfolio literally melts before our eyes, but you need to understand that any recession eventually ends and it will be replaced by an inevitable and superior growth.
This is how the economy works and its component part called the stock market is a constant cyclical development consisting of successive ups and downs. And in the end, each successive rise is at least slightly (and sometimes quite strong) but surpasses the previous decline, so it turns out that in the long term, the stock market is steadily growing up.
Reconsider your attitude to market downturns radically. Think of them not as losses, but as opportunities for buying and, accordingly, future earnings.
To avoid making investment decisions under stress, make a crisis investment plan ahead of time. If you are now adding $ 500 to your investment account every month, then make it a rule to add the same amount for every 5% decrease in the S&P 500 index.
This means that if the index drops 25% per month, you are investing an additional $ 2,500 on top of your regular $ 500 monthly contribution.
If you do not want to bother with the choice of stocks, you can invest in an ETF following the same S & P500. When the recession is over, the index will first restore its pre-crisis values and then continue to grow further. And along with the index, so will the ETF that tracks it, and your money invested in it.
Here, for clarity, is the S & P500 chart. As you can see, any recession inevitably ends with a growth that exceeds it:
Step 2: Create a financial cushion for at least 6 months
Losing a job or major unexpected expenses right after a stock market crash can take a hard hit on your investment portfolio. The need to cash out (sell stocks) while your investment is down 20-30% can wipe out years of progress.
Selling shares in a falling market would be in complete contradiction to the rule outlined in the previous paragraph. Selling in this way, you will lose the accumulated profit for years and in the future, to replenish the portfolio to its previous conditions, you will need much more money (after all, the market always recovers after a recession)
For such a case, you need to keep in your savings account an amount of money sufficient for a comfortable existence for six months. Establishing this kind of emergency fund is not an easy task and can take years, but it is one of the necessary tasks that needs to be solved on the way to your financial freedom. If the idea of creating a six-month emergency fund sounds overwhelming, try breaking it down into smaller pieces and starting by building one month, then one more month, and you will reach your goal.
Step 3: If possible, have additional sources of income
In the wake of massive job losses in 2020, many personal finance experts have begun recommending a 12-month emergency fund to their clients (although prior to that the six-month airbag was the gold standard).
In fact, there is no amount to guarantee that an emergency will not devastate your budget. In my opinion, the reserve of money for the next six months is quite enough to feel quite comfortable without worrying about the possible loss of a job.
However, it would not hurt to think about having a couple of additional sources of income in addition to the main job.
Step 4: Save Money Separately from the Stock Market
In addition to investing in the stock market, there are still many pressing issues associated with high financial costs: buying a house, car, training, etc. That is, in addition to monthly replenishment of your investment account, you may have to set aside a certain amount of money to buy, for example, your house.
Here you need to adhere to a strict rule: in no case do you mix investment capital with your other savings.
After the next takeoff of the stock market, you may naturally be tempted to invest all your savings in stocks (including those that are intended for purchases in the relatively near future). When the value of an investment portfolio increases by 20-25% in six months, it is “painful” to look at how your other savings are modestly placed on a bank deposit at 2-3% per annum.
But you have no idea when the market will crash, so the general rule of thumb is that you should keep the money you need for the next five years outside of stocks. The ideal place for this is a bank deposit. No matter what happens in the stock market, your money will be safe until the right opportunity presents itself (or the necessary amount is accumulated) to buy.
Step 5: Invest as if there were no crises or crashes
We find out that we are in another bubble only after it bursts. This can happen now or in a few years, so every month you need to keep investing no matter what. If you ditch your investment now for fear that the stock market is overvalued, you could be missing out on invaluable profits in a few years.
Instead of worrying about what will happen to your investment portfolio in a month or even a year from now, focus on the long term. Don’t trust the shares of domestic enterprises? Then invest in time-tested US stocks. Within 10 years, your chances of making money investing in the US stock market are well over 90%. Historically, over any 20-year period, the S&P 500 has never been a loss.
This is just the data of dry, unbiased statistics and it is much better to trust them by systematically investing (adhering to the above rules) than to panic and postpone investments due to the next market collapse.
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