There are lessons to be learned from stock market crashes. It’s a shame that many people don’t learn them. There have been many market crashes. The two I remember most are the 1987 crash when the market went down 22% in one day and the other is the financial crisis from 2007 to 2009 when the market lost 50% of its value.
In the current Coronavirus market crash we have seen the market drop about 30% from its high. We don’t know where the bottom of the market is or when this national crisis is going to be over. It is easy to assume the worst. There is no question there are going to be major dislocations for both individuals and businesses. There are many unknowns, just like there were in all of the other market crashes. But panicking and selling stocks at times like this is a huge mistake.
There are always risks when you invest and the stock market is unpredictable. There will be times when the market has major problems and goes down but investing in the market is still one of the best ways to achieve your goals. These days with interest rates so low most people cannot have a comfortable retirement or meet long-term goals without investing in stocks.
The lesson of stock market crashes is to have a plan that limits your risk. Historically, stocks have returned about 9% per year over the long term and with interest rates on CD’s at 1% it is even more important to include stocks in your portfolio. You need growth even if you are retired because those retiring today may need to draw income from their nest egg for 30 years. Just investing in super safe investments may not get you there.
How can you invest in stocks and limit your risk? Look at your savings all together as a portfolio. Decide how much you can put in stocks and still sleep at night. Keeping in mind that having zero in stocks is not an option for most people if they don’t want to run out of money. Said another way, decide how much money can you put aside for growth and keep that as a constant percentage of your assets.
Let’s assume you are married, age 65, retired and have a nest egg. You need to pull some money out of that nest egg every month. Assume you decide to put half your money in stocks and the other half in fixed, stable assets. Half of the money is for growth and the other half is in stable assets like bonds, CD’s, bond funds and cash. You take your income from the stable assets and leave the growth to increase in value.
This is known as a total return strategy. The stock or growth part of your savings will fluctuate in value – and sometimes the markets crash. This is part of investing it happens. Market crashes do not affect the fixed income portion of your assets, the place where you get your income.
The total return strategy only works if you have a plan to actively manage your assets by doing the right thing at the appropriate time. In the above example this stock market crash is an opportunity, you should buy stocks while they are down and bring your mix back up to half again. Then, when times are good and the value of your stocks is above half of your assets sell some stocks to get your mix back down to half. Keeping your stocks at a constant percentage of your portfolio is the key. It forces you to do the right thing at the right time. Buying stocks when they are low and selling high is a winning strategy.