How can you prepare for a stock market crash?

Stock market crashes are simply a fact of life. They don’t happen often but they always happen eventually and when they do they can decimate your portfolio. Fortunately, there are a few steps you can take to limit losses and ensure that your investments bounce back quickly.

  1. Do not sell. During a crash you will experience huge emotional pain and the temptation to sell will be high. The problem is accentuated by the ongoing bombardment of opinion and information we receive in today’s internet age. It may be best to avoid looking at your portfolio altogether to counter the urge to sell at these times.
  2. Keep a decent chunk of cash at all times. How much is a personal judgement, but I would say at least 10% is sensible. Having cash to deploy when sentiment is dire and prices are crushed is the only way to create opportunity out of this horrible experience. Maintaining a shortlist of businesses that you would like to own at lower prices will help you make the right purchases when the time comes.
  3. Only hold high conviction stocks. These are cheap stocks of high quality businesses. What these are will vary from person to person. Although “one man’s trash is another man’s treasure” the crucial thing is that you personally have high confidence in each of your investments. If you don’t, then it will be impossible to resist the urge to sell during a crash. A simple test of conviction is being able to crystalise the value proposition in a few sentences.

Always remember that a stock price is simply the last price someone was willing to pay for a business. This rarely coincides with the true worth of that business, which is equal to the total future cash flows discounted for the time value of money.

The beauty of owning high-quality businesses is that future cash flows keep rising and so it is hard to pay more than they are worth. However, almost any stock is a buy at a sufficiently low price and every stock is a sell at a sufficiently high one.

Regardless of which stocks you buy, you should only hold them if you strongly believe they are worth more than the current share price. If you follow this rule, then why would you think about selling when prices crash?

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Motley Fool contributor Matt Brazier has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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