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Are You Prepared for the Next Stock Market Crash?

Nov. 5, 2014
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By Phillip Christenson

Learn more about Phillip on NerdWallet’s Ask an Advisor

Are you a little scared after the recent volatility of the stock market? Are you thinking back to 2008, when stocks dropped almost 50%? Think it can’t happen again? Well it can, and it probably will. But I don’t know when and neither does anyone else. The best thing: Prepare now for the coming crisis whether it’s in 2015 or 10 years from now — and that doesn’t mean sticking your money in a bank account.

There are only two things you need to do to prepare for the next financial crisis. The first has to do with your portfolio, and the second is about you, the investor.

Asset allocation is key

Simply put, asset allocation is the mix of stocks and bonds in your portfolio. Historically, bonds tend to be less volatile than stocks. While this is usually true, some bonds can be just as risky (or even more so) than stocks. Junk bonds, for example, pay you a higher rate of interest than other investments because they carry more risk. I suggest avoiding these bonds and instead stick with low risk bonds, which means short-term and high-grade bonds. While this kind of bond pays a lower interest rate, they most likely won’t drop like stocks or riskier bonds did in 2008.

The key is to calculate the amount of cash you are going to need from your portfolio in the next five, 10 or 15 years (depending on your risk tolerance) and invest this amount in safer high-grade bonds. (Note: You can invest in this kind of bond through a mutual fund or an exchange-traded fund rather than buying individual funds.) By doing this, you can confidently invest in the stock market knowing that the cash you need is invested in a less volatile asset. If the market does go down, you can be a patient seller and wait until the market turns around to sell stocks. An average bear market takes from 2.8 to 5.2 years to recover, so you can wait out almost any market decline with this strategy.

It’s all about your perspective

Don’t lose sight of the fact that the stock market is a market like any other. It’s a place where people gather to buy and sell. And like any other market, sometimes sellers have to offer discounts to sell more products, or in this case to unload their stocks. So think of a bear market as similar to a sale on your favorite stocks. If you picture the stock market this way, you will learn to love a down market. During a market decline, you are able to buy more shares in the same companies, but at cheaper prices.

Whether you are young or old, if you use the bond strategy that I outlined, you’ll be wishing for a market like 2008. Then, you could buy stocks at almost 50% off all the while knowing the cash you need is safely set aside in the right kind of bonds. Even in the Great Recession, it was only five years before we started reaching new highs in the market.

That’s it. Two steps and you are ready for whatever the market brings. But you need to be sure to do both steps. If you adjust your portfolio, then panic after the market goes through a correction, you will be no better off. Adjust our portfolio, adjust your thinking and you’ll be prepared for the next market crash.