You may not like what I’m about to say, but it’s the truth: A stock market crash is inevitable. Of course, we don’t know precisely when the next crash will occur, how long it’ll last, or how steep the decline will be. But we do know that, based on history, double-digit declines in the benchmark S&P 500 (SNPINDEX:^GSPC) are more common than most investors probably realize…
History is clear: A crash is coming
If we were simply to take a walk down history lane and let the averages guide us, the prospect of a double-digit correction or crash over the next 12 to 18 months is very high. For example, every single bear market dating back to 1960 (not counting the coronavirus crash from 2020) has had at least one double-digit percentage retracement within three years of hitting a bear-market bottom. More than half of those bear markets actually had two double-digit declines within three years. We’re now nearly 14 months removed from our bear-market bottom and have yet to face a double-digit drop in the S&P 500.
Furthermore, the S&P 500’s Shiller price-to-earnings (P/E) ratio is worrisome. The Shiller P/E ratio, which takes into account average inflation-adjusted earnings over the previous 10 years, closed at 37.32 this past week. The 150-year average Shiller P/E for the S&P 500 is only 16.82.
But the real concern is that each of the previous four times the S&P 500’s Shiller P/E has crossed above and sustained the 30 mark during a continuous bull market, it’s subsequently declined by a minimum of 20%.
Also, there have been 38 double-digit percentage drops in the S&P 500 over the past 71 years, according to market analytics company Yardeni Research. That’s a sizable drop, on average, every 1.87 years.
History is pretty clear: A crash or sizable correction is inevitable.
Your 10-point checklist for the next stock market crash
However, this doesn’t have to be bad news for long-term investors. As long as you’re prepared mentally and financially for a crash, it can actually be an incredible moneymaking opportunity. Below is a 10-point checklist to get you prepared for the next stock market crash.
1. Breathe, this happens all the time
The first thing to do when panic-selling crops up is to breathe deeply and realize that this is a normal part of the long-term investing process. You might even call it the price of admission to the greatest wealth creator on the planet.
As noted, a double-digit decline has occurred every 1.87 years since the beginning of 1950. But what you might not realize is that every single one of these 38 crashes and corrections in the S&P 500 has been erased by a bull-market rally. In many instances, it’s only taken weeks to a few months to put sizable drops in the rearview mirror for good.
2. Understand your risk tolerance before a crash occurs
Well before the next crash or sizable correction strikes, it would be a wise idea to understand your investment risk tolerance. For instance, if the sight of your high-growth stocks losing 50% is going to cause you to lose sleep, you probably shouldn’t be invested in growth stocks. I use this as an example because a lot of the top-performing growth stocks over the past year did, indeed, lose close to half their value during the coronavirus crash.
Keep in mind, though, that investing conservatively doesn’t have to mean giving up significant wealth creation. Hypothetically speaking, if you had purchased an S&P 500 tracking index in 1980, you would have endured the worst single-day crash in 1987, the dot-com bubble, the Great Recession, and the coronavirus crash. Your reward? An 11% average annual total return (including dividends) even with these declines.
3. Take the time to regularly reassess your holdings
Though you don’t have to wait for a crash to crop up, panic selling in the broader market is always a good time to step back and reassess your holdings. By this I mean evaluate whether or not your initial investment theses still hold water. In many instances, the reasons you bought into a stock in the first place are unlikely to be altered by a stock market crash or correction.
In the rare event that your investment thesis is altered or broken, it might be worth selling your stake or reducing your position.
4. Ignore emotion-driven white noise
We’re normally not going to know what causes a stock market crash until it’s well underway. But the biggest driver of crashes isn’t necessarily news. Rather, it’s the emotion-driven panic of short-term traders.
We can’t control how other investors are going to behave when stock market crashes pop up. What we can do is lean on history and our investment research, which tells us that crashes and corrections are often very short-lived. Ignoring the raw emotion that rises to the forefront in the very short term during stock market crashes is important to building wealth over the long run.
5. Have cash at the ready to take advantage of discounts
This might go without saying, but it’s always a great idea to have some dry powder at the ready to go shopping when the stock market crashes. Since every single crash or correction is eventually wiped out by a bull-market rally, it means every major dip in history has proved to be a…
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