Investors are feeling spooked.
After more than a year of moving up and to the right, U.S. markets have dropped 8% in the last five trading sessions, triggering the first real concerns that a crash could be coming.
It’s not a question of if, but when.
That doesn’t mean now’s the time to panic. The correction U.S. markets saw last week was just that: A correction, and an overdue one at that. But even though the sky isn’t falling at this precise moment, it’s a mistake not to be prepared for when a crash eventually comes.
Luckily, there are ways to navigate the stormy waters of a stock market crash. The key is following the “3 D’s”: Get defensive, get disciplined, and get deep.
The old adage is that there’s always a bull market somewhere. Trite or not, that saying is well known because there’s some truth to it.
Many investors don’t realize that there were actually major stocks that made money during the financial crisis of 2008. McDonald’s (MCD – Get Report) handed investors 8.54% total returns that year. Walmart (WMT – Get Report) rallied 20% on a total-returns basis as the rest of the market was melting down. And discount retailer Dollar Tree (DLTR – Get Report) surged some 60.8% that year.
What did all of those stocks have in common? They’re defensive.
When markets roll over from bull to bear territory, the stocks that get punished the hardest are the most speculative ones. Risk-off environments necessarily mean that the issues that worked the best when speculators were happy are the exact same ones that get hit the worst during a flight to quality.
In low interest rate environments in particular, dividend payers are a stellar way to get defensive.
That’s because dividends are by definition a positive contributor to your total returns, even if prices are plunging. The caveat is not owning stocks whose dividends are unsustainable in difficult economic conditions — dividend cuts get punished in market crashes.
In the wake of 2008, many investors stayed very defensive in their portfolio allocations for a prolonged period. That’s been shifting in 2017 and 2018 as investors got more comfortable with low volatility and big rallies. Getting back to a somewhat more defensive position in your portfolio is a smart way to protect against the next market crash.
Typically, that means underperforming during the final stages of a colossal rally as the most speculative bets surge higher. But the stats make it clear that simply taking less of a drawdown by remaining more defensive absolutely outweighs any missed upside potential when viewed across a full market cycle.
In a market crash, your emotions are your enemy.
Research from Dalbar consistently shows that emotions are the reason why retail investorsdramatically underperform the broad market averages across nearly all timeframes. Humans are programmed to buy at asset-bubble tops and sell at market bottoms — and that’s precisely why being disciplined is a key piece of surviving the next market crash.
Discipline means holding onto good stocks, even as they move lower. And it means avoiding the compulsion to make speculative, risky bets to “get back to even”.
One key to being a disciplined investor is having some systematic way to quantify whether an investment is still worthy of being in your portfolio.
There are plenty of tools you can use to determine whether a stock is attractive – be they fundamental, technical, or (better yet) some combination of the two. Critically, that yardstick shouldn’t change just because market conditions change.
The best time to buy is when there’s blood in the streets.
That’s a concept that’s held true across centuries of investing — and it’s just as true today.
When markets crash, investors are generally presented with outstanding buying opportunities in oversold stocks. Finding those opportunities means getting deep into those stocks’ valuations.
Markets tend to overcorrect both to the upside and the downside. Often, that means stocks can trade for valuations during market crashes that don’t make economic sense. That was certainly the case in 2009, when many companies were still throwing off substantial cash despite trading for tiny multiples. Following the first two D’s (defense and discipline) is key to having enough dry powder to take advantage of getting deep when equity valuations plummet.
There’s still no indication that we’re coming up on any sort of crash. The correction we’re experiencing in 2018 has all the hallmarks of a normal, healthy correction following a rampaging bull market push. But even if a crash isn’t knocking on the door today, it’s inevitable that we’ll see one again down the line.
Following the 3 D’s — get defensive, get disciplined, and get deep — is the key to surviving and profiting from the next one.