What To Do When The Stock Market Crashes: A Complete Guide

When your portfolio value decreases significantly in the falling stock market, it becomes obvious to ask, "Should I release my investment from the stock market?" It is logical to feel like this.

However, there are better ways to deal with such a situation. You only lose your investment once you cash out, so don't worry about the highs and lows in the interim.

This blog discusses a stock market crash - what it is and ways to hedge your portfolio against market risk and protect your investments during such a tumultuous time.

1. What Is A Stock Market Crash?

A stock market crash is a sudden and unexpected drop in stock prices in the broader market.

It is defined as a drop of a minimum of 10% on a stock exchange or primary index in one day or over a few days.

A stock market crash may be temporary. In minor crashes, the stock prices usually recover within days or weeks. However, a crash can also indicate the beginning of a longer downturn lasting for months or even years.

Some of the major crashes in the history of the stock market include:

• The infamous Wall Street crash of October 1929- Great Depression that lasted several years

• Black Monday (1987)

• The dot.com bubble (2001-2002)

• The global financial crisis (2008-2009)

• The COVID-19 pandemic (2020)

2. What Causes The Stock Market To Crash?

A crash usually occurs every few years, and investors question whether companies have become overvalued.

There could be various reasons behind a stock market crash, some of these include:

• A continuous bull market period led share prices to rise for various years. After the bull markets end, stock market crashes tend to be solid and last longer. 

• Economic changes include the news that the Federal Reserve will amend its monetary policy strategy.

• Geopolitical issues

• Emergence of pandemic like Covid-19 

• Macroeconomic factors such as inflation rates are at their highest level in over 20 years in Australia, which led central banks to raise interest rates to curb inflation. 

The rising interest rates negatively influence the stock markets for the following reasons:

• Reduces valuations of 'growth' stocks by reducing the present value of future cash flows.

• Reduced consumer spending due to inflation.

• Switching from shares to cash-based products.

To make the stock market crashes worse, quick market declines can lead to forced trades by speculators who borrowed funds to purchase stocks and are subjected to margin calls and liquidation of holdings, leading to a series of selling.

While the stock market crash triggers vary, the ultimate result is always the market's recovery.

3. How Do Market Crashes Differ From Market Corrections?

Crashes and corrections in the stock market differ based on the depth of the decline. A stock market correction is a drop of over 10% but below 20%. A stock market crash is a decline of 20% or more.

A market crash is highly detrimental to investment portfolios and probably your lifestyle. The average bear market usually lasts over a year and a half. It takes almost two and a half years or longer for the market to recover.

Stock market corrections occur more frequently than crashes but are softer than crashes. They usually take five months to reach the extreme of a correction. Once the market turns positive, it can recover quickly in four months.

4. What To Do When The Stock Market Crashes In Australia?

Often, investors ask this question - what to do when the stock market goes down? 

Knowing that stock market crashes can happen allows you to get ready and respond smartly.

Here, we've laid out simple options to help you make the right moves when the market takes a dive:

Option 1: Do Nothing

Having a long investment timeline and properly diversified makes it easier to ride out the downturns.

There is no need to amend your investment strategy unless you have a good reason.

Option 2: Buy The Dips

Crashes are the period when you can buy stocks on sale.

Market dips create a buying opportunity where you can consistently purchase your chosen stocks on your regular investing schedule or index funds on a regular pattern.

Option 3: Consider Dollar-Cost Averaging

Dollar-cost averaging is a way to average your purchases by making purchases of a fixed dollar value at regular periods, including in the downturn market.

Spreading your buys this way helps lower your risk as you don't invest your entire investment capital at a particular price point.

Option 4: Seek Dividend Stocks

Though there is no guarantee of getting dividends, companies that issue dividends are more mature and have less volatile share prices.

As a result, dividend investing can prove to be a valuable strategy when share prices and returns are on the decline.

Option 5: Switch to Another Sector

Switching funds between different market sectors is another strategy to deal with market downturns. Tech stocks are good performers during high-growth bull markets.

However, utilities and consumer staple sectors are preferred when the economy slows. Strategically moving between industries can help avoid significant dips in a specific sector.

Option 6: Go for Bonds

Bonds are a good way to offset stock market risk within a portfolio.

Given their history of flawless repayment, they are ideal assets in down markets. Government bonds like Treasury bonds are the safest investment during times of uncertainty.

They outperform stocks in an equity bear market as central banks reduce interest rates to stimulate the economy. Riskier bonds like high-yield credit and junk bonds go down with the falling stock prices and so do not fare well.

Option 7: Cut Down on Losses and Save on Taxes

Cutting your losses is beneficial as it frees up money for different investment assets, provided you invest in a taxable account.

With a tax-loss harvesting strategy, you can claim your tax losses. It allows you to offset income with losses you realise, which could reduce your tax bill.

Option 8: Focus On The Long-Term

A long-term focus enables you to perceive major bear markets as wealth-building opportunities.

When most investors sell stocks regardless of their quality, focus on adding blue chips shares at attractive valuations and prices to your holdings.

How To Prepare For A Stock Market Crash?

The stock market moves in cycles. At some levels, stocks overheat, and selling corrects high valuations. After a gradual decrease in stocks, when they become oversold, buying surfaces again.

Preparing for a stock market meltdown depends on various factors, majorly your risk appetite and time horizon. Identifying your goals will help you better prepare for the right course of action if stocks should go south.

Here are some ways/tips to help you prepare for a stock market crash:

• Manage your emotions. Try to avoid checking your portfolio. Stick to your long-term strategy to get the most from your investments.

• Invest long-term as the probability of losing money decreases as your investment time horizon increases.

• If you are nearing retirement, you should build your cash reserves and "de-risk" your asset allocation. Consider switching some of your stock investments to more stable assets like bonds, money market funds, or high-yield savings accounts.

• Resist the temptation of panic selling and panic buying during market corrections. Wait to find the best time to invest at reasonable valuations. Low-risk assets like Index Funds, Debt Mutual Funds, Gold, or blue chip stocks are ideal for investment during market crashes.

• Understand your investment decisions, what you own and what you want your money to do. It will help you analyse your stocks in good and bad times and better withstand a stock market crash.

• Another thing you can do in a stock market fall is to rebalance your investment portfolio. It involves buying and selling investments periodically to maintain your targeted allocation in each asset class. It helps reduce the overall risk in your portfolio to offer better risk-adjusted investment returns. A stock market crash is an opportunity to sell your Treasury securities and use the released money to buy stocks as they move in opposite directions. Maintain a diversified portfolio with specific asset allocation. Plan how and when you will rebalance your portfolio at set intervals.

• De-risk your investment portfolio to ensure it is built to withstand as much risk as possible. It helps you to handle stock market volatility and weather a stock market correction or crash.

• It is usual for unseasoned investors to react poorly when something scary happens, like a stock market crash. A Robo-advisor is an ideal money management tool that doesn't respond out of fear like most inexperienced investors. It selects the best investment assets, such as bonds and stocks, based on complex algorithms when the stock market is in flux. Robo advisors have many features, such as automatic tax-loss harvesting and a new cash account without minimum investment.

• The next thing you can do to handle a stock market crash is to capitalise on tax laws. Your profits on selling stocks or mutual funds attract short-term or long-term capital gains. A stock market fall is an opportunity to benefit from tax-loss harvesting and enhance the after-tax returns on your investment. 

• Most investors use this strategy towards the Financial Year end to sell their poorly performing assets to book a capital loss and replace them with potentially better-performing investments like long-term investments with multi-year lock-in periods. The accumulated capital loss can then be used to offset against capital gains incurred from other investments. It will help them lessen annual tax liability and improve the after-tax returns from their investments and the asset allocation mix of the investment portfolio.

• A stock market correction is not the time to take on additional debt. However, you can use this critical economic situation to refinance existing debt, particularly when you have a good credit score and have made timely payments of your EMIs.  

5. Frequently Asked Questions (FAQs)

Can The Stockmarket Go To Zero When Crashing?

The stock market has crashed before, like in 2008, when prices plummeted due to massive selling.

However, strong companies always bounce back. The stock market doesn't just go to zero; it has ups and downs.

These dips let smart investors buy great stocks at lower prices. So, if you've invested in good stocks, you won't lose everything. Your stock's value might drop temporarily, but good stocks usually recover and reach new highs in 2 to 3 years. (no guarantee)

Stocks are for brave and patient people. A stock that was once half its price during a crash can now be worth twice or thrice as much.

Don't fear; invest wisely. Quality companies, diversification, regular investments, and a long-term approach help you survive the market's ups and downs and reap big rewards over time.

What To Do When The Stock Market Crashes Today?

Nothing, if you don't need money urgently.

If you are invested in industry-leading companies, sit back and relax. You can start buying stocks (of existing companies or companies you always wished to purchase but couldn't due to their high prices) in small units each time it falls by 5% further.

This way, your average investment value in a stock will reduce. As it is certain that the market will recover in due course, buying more quantities at a lesser price will lead to more gains than if you have just waited for the market to recover due to no spare funds.

Always remember Warren Buffet's principle - Be greedy when others fear, and be fearful when others are greedy. Become a value investor rather than a momentum investor, particularly when the stock market crashes.

In a market meltdown, avoid following the herd, i.e., when others are selling, don't do the same thing. It becomes easier to sail through that phase when you have invested in quality companies and only the funds you don't require in the next 5-7 years.

Only then can you wait with unending patience and reap massive rewards like ace investors.

What Happens To The Economy When The Stock Market Crashes?

A decline in stock prices has the power to cause widespread economic disruption.

Some crashes attack economies for years, while others merely shake up investors' convictions, making them more cautious.

Human tragedies and revolutionary government reforms are other economic impacts of stock market crashes. Let us look at historical market crashes and their effects:

• The Panic of 1907 - A few banks and stock brokerages failed. Many top executives at financial institutions got fired. Businesses that couldn't secure bank loans also failed.

• Wall Street Crash of 1929 - The stock market crash caused massive underlying economic problems and magnified them. A sudden rush for money withdrawal caused overextended banks to fail and deprived customers of their savings.

By being deprived of lenders, many businesses started to collapse, leading to goods shortages. Additionally, 5% of Americans lost their jobs, encouraged foreclosures, migration, and a 30% drop in Gross domestic production.

What Goes Up When The Stock Market Crashes?

Treasury bonds, gold, silver, short stock positions (put options), Money Market Funds, stock inverse ETFs, and stocks in specific sectors, like consumer staples or companies that profit from economic adversity, often rise when the broad stock market decreases.

Do You Lose All The Money If The Stock Market Crashes?

No. A stock market crash only signals a decline in stock prices where most investors incur losses but don't completely lose their entire money.

In an actual sense, one loses money only when they sell the positions during or after the crash.

Given the volatile nature of the stock market, if it falls today, it will also rise sooner. (no guarantee)

6. Conclusion

Stock market crashes are inevitable and can be financially and mentally devastating.

However, you can reduce the intensity of potential losses if you are prepared to deal with such a turbulent time. Panic selling in a bear market can eventually hurt your portfolio instead of helping it.

Designing your portfolio as per your risk tolerance, time horizon, and market performance during downturns will help you weather a market meltdown better and grow your wealth substantially when the markets recover.

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