How To Protect Yourself From A Stock Market Crash

panic

It’s been over ten years since the stock market took a major tumble that took stocks down 50%. During the next decade since then North American stocks, specifically the United States, have enjoyed the longest bull run in maybe the history of the US economy.

Despite the cries that the American empire was crumbling, the DOW Jones Industrial average has tripled since then. This means that even if you had bought stocks in 2007 before the crash and didn’t sell anything in 2008, you would still be up double. Unfortunately for the doomers, America didn’t unravel and the empire didn’t fall even with the election of President Trump.

Headwinds Ahead

It’s quite unusual for the economy to keep rumbling ahead, especially one that has forged ahead for the greater of a decade. Remember what the great investor Warren Buffet once said, be “Fearful when others are greedy and greedy when others are fearful”.

Last year markets tanked 20% from the peak. To begin 2019 we’ve seen the stock market surge over 10% in both the US and in Canada. As I wrote in one of my previous posts, the gains for the year might already be over. We might be seeing more volatility going forward as the interest rate hikes of last year finally take affect on average households.

One of the major headwinds that face Canadians is the ever rising debt levels of the average Canadian. Despite record low interest rates, Canadians didn’t use the opportunity to pay off debts like student loans or mortgages. In fact, opposite was quite true.

Canadians borrowed themselves silly and now the average Canadian owes over 178% of their annual income in debt. This is the average, so it means for every person with no debt like a child, there’s an adult that owes over 350% of their disposable income. This had led Canadian households to require almost 15% of their monthly disposable income to service debt payments only.

In a service and consumption economy like Canada, this is bad news. For every dollar that is spent paying interest for prior purchases, future growth is taken away. During the 2008 financial crisis, normal Canadians saved the economy by gorging themselves on debt. Now we’re starting to pay the price as normal households are starting to feel the pinch even with a 1% hike in interest rates.

Stay Committed

Since we’re starting to see the economy slow it’s important to understand that we do not want to start panicking and making irrational decisions with our long term investments. One of the worst things to do is to sell everything in haste due to an emotional outburst.

When we sense that markets have done really well, like we already have in 2019, it’s time to reflect on our investment portfolio to see if we’re still balanced. One of the worse habits as investors is that we love chasing gains. Greed is our enemy.

Now that markets have climbed up from the 20% correction at the end last year, it’s enticing to continue to chase these gains by buying more stocks, but this is the time to re-balance. If you re-balanced at the bottom, it’s smart to re-balance at the top.

One thing to avoid doing now is buying more weed stocks, chasing Bitcoin and buying more junior oil companies that have come off their lows. The smarter play right now is to get yourself into some bonds. Play it safe, collect some interest and perhaps even see some capital gains as interest rates continue to fall.

Keep Bonds In Portfolio

Bonds are boring and people look at them and wonder why it’s worth buying even when they only pay a measly 2.5% in annual interest. The reason why we should all own bonds, and a great deal of them, is to protect ourselves from market corrections.

Stocks go up long term and by that I mean over a 10 year period. Why most people fail with investing is that they look short term and when losses pile up they run for the exits. Bonds are there to help during the bad times. It’s the parachute you want when stocks start falling from the skies.

Bonds have historically had a negative correlation with stocks. This means when stocks rise, bonds fall. The opposite is true when stocks fall. Bonds will rise in price as interest rates fall. This pattern has existed for decades.

Just how much bonds one should hold really depends on risk tolerance. Though for many people I feel no less than 40% should be in bonds. In fact, 90% of the people investing shouldn’t go below 40% in bonds. From my own personal experience talking to people, many cannot stomach a turbulent stock market.

A 60-40 split between stocks and bonds or even 50-50 is what most people should aim for when investing long term. This means with 20% correction in stocks, the worst an individual would lose from the market would be closer to 10%. With a 50% correction in stocks, someone holding more bonds would only see a decline around 20-25%. This is probably the most any average Canadian can stomach.

It’s Not A Race

The most important thing to remember about investing is that it’s not a race to get rich. Investing is not a get rich quick scheme. It’s a lifelong commitment. Too many people think that money can be made quickly by gambling on stocks. This is NOT the same as investing passively.

This blog, and many others focusing on financial independence, have always preached a passive balanced portfolio as a way to grow wealth. What really matters to gain wealth isn’t about what we buy, but it’s about how long we stick with it.

Maintaining balance is the key to keeping your portfolio safe from stock market crashes. Just resist the urge to chase stock market gains. Be happy with the slow and steady pace. Remember, if you’re just starting off, it’s not about what you are buying, but what you are saving that matters most.

 

 

 

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