This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
As the first part of 2022 so brutally reminded us, stocks can go down as well as up. If you're not prepared for that reality, then a market crash can feel incredibly terrifying to live through. After all, it feels like you're watching your life savings slip away, often at the same time that your job seems to be at risk due to cost cutting driven by lack of investors' or leadership's confidence in the future.
In a world where that's the ugly reality you're facing, sleeping easy through a market crash might seem like an impossible dream. Believe it or not, it is possible to set yourself up to make it through a really rough market and wind up better on the other side. It takes pre-planning, discipline, and accepting the trade-offs that come with proper risk-management in your investments. With that in mind, here are four ways to sleep easy in a market crash.
No. 1: Have an emergency fund
One of the biggest challenges you'll face is the fact that your costs don't go away just because the stock market is down. Being forced to sell your stocks while they're down to cover a bill is a great way to turn a temporary market dip into a permanent loss of capital. Recognizing that risk only after it's staring you in the face adds a substantial amount of tension to what is already a bad time.
With an emergency fund that has three to six months of expenses in it, you have a buffer that can help you navigate through short-term challenges without immediately having to tap your long term money. That's a huge benefit when it comes to sleeping at night.
Of course, in today's inflationary environment, it may not be a great idea to have too much tied up in cash, since that cash is so rapidly losing purchasing power. That's why it's also important to balance your short-term cash needs with your longer-term financial plan to more completely manage the risks you face.
No. 2: Keep money you know you'll need soon out of stocks
If you expect you'll need money from your portfolio in the next five or so years, that money does not belong in stocks. Instead, it belongs in something like duration-matched Treasury or investment-grade bonds where you'll have a higher likelihood of having the cash you'll need when you need it. You won't earn high returns on this money, but if the stock market happens to be crashing when those expected bills come due, you'll be incredibly glad you had it in higher-certainty assets.
Knowing that you can still reach your important, nearer term life priorities even as the market is crashing around you is a critically important tool that can help you sleep at night. Like with an emergency fund, the lower returns you can expect to earn on this money mean you shouldn't over save in this bucket, especially in a high-inflation environment. Finding the right balance can also be important in your ability to sleep easy during a market crash.
No. 3: Avoid portfolio margin
The margin that your broker likely offers you is a knife that cuts both ways. When the market is rising rapidly, it can magnify your returns and make you feel like an investing genius. Once the market turns sour, though, your losses will be magnified as well. As if that weren't enough, most margin loans come with substantial interest attached. That interest gets charged based on the amount you borrowed, not based on the amount your portfolio is worth.
On top of all that, when you're using margin and the market moves far enough against you, your broker can issue a margin call. When that happens, you must either come up with cash, liquidate holdings, or find another way reduce the risk profile in your account. If you don't, then your broker will liquidate your positions for you until that call is satisfied.
Put it all together, and having margin takes the pain of a market crash and makes it substantially worse. Avoiding that margin goes a long way toward helping you sleep easy when the market is crashing.
No. 4: Recognize the value of what you own
Ultimately, a share of stock is nothing more than a small ownership stake in a company. That company has a value based on its ability to earn money over time. By estimating how much the company will earn over time, then adjusting for your stake in it, you can get a reasonable ballpark estimate of that value.
A technique like the discounted cash flow model can be useful on that front, as it can let you quickly change your estimates and come up with a range of values based on the scenarios you lay out. Because you're dealing with the future, you'll never get it perfect, but you can usually get close enough to make reasonable investing decisions.
With a tool like that on your side, you'll start to see cases where a market crash is really an opportunity to buy great companies for less than they are really worth. Especially if you've done a great job with the other three ways to sleep easy in a market crash, this one can really help you sleep easy. After all, this is the one that can transform you from a panic seller into an opportunistic buyer, which can be a great way to see your net worth improve in any subsequent recovery that may follow the crash.
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It's never easy to live through a market crash. Still, with some decent planning and a willingness to accept the trade-offs involved, you can get yourself to where you're sleeping far easier even as the market is crashing around you.
It is far better to have your plans in place before the market crashes, but if the market's recent decline is what it takes to get you to put a better plan in place, then so be it. At some point, the market will crash again. The plans you start putting in place today should serve as a great foundation for getting you ready to sleep that much easier whenever the next crash may come our way.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
