Last week served up a timely reminder that ASX shares can turn lower quickly. The S&P/ASX 200 Index (ASX: XJO) began the week above the psychologically important 9,000-point mark, a level it had comfortably held for more than a month.
By the end of the week, however, the benchmark had fallen more than 3% to around 8,741 points.
That sharp move may have investors asking an uncomfortable question: are we watching the beginning of a broader stock market crash?
The truth is that nobody knows when the next crash will happen. What history does tell us is that severe market declines are an unavoidable part of investing.
Rather than attempting to predict the next sell-off, I prefer to prepare for one. That means stress-testing my portfolio and asking whether I could remain rational if ASX shares suffered a much steeper decline.
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Could you survive a 30% downturn?
Market crashes can seem like distant possibilities when share prices are rising. But investors only need to look back to early 2020 for a reminder of how quickly conditions can change. During the COVID-19 panic, the ASX 200 plunged roughly 30% between January and March.
The next downturn could have an entirely different trigger. Its timing and severity are impossible to know.
So I ask myself a simple question: what would I do if my portfolio, with ASX shares fell 30% tomorrow? Would I panic and sell? Or would I be comfortable holding?
I also consider an even more extreme scenario. How would I react if my portfolio lost 50%?
These aren't merely hypothetical exercises. Investors who haven't considered their tolerance for substantial losses beforehand may be tempted to sell at precisely the wrong moment.
If a 30% or 50% decline would make you sell, it could be worth reassessing your portfolio's risk profile now.
Is your portfolio too concentrated?
Diversification can provide an important buffer against company-specific and sector-wide shocks.
For example, owning several ASX shares doesn't necessarily mean you're well diversified if most of your money is concentrated in a few companies, sectors or economic themes. Investors should consider how much exposure they have to major names such as BHP Group Ltd (ASX: BHP) and Commonwealth Bank of Australia (ASX: CBA), among others.
Holding businesses across different industries and, where appropriate, different asset classes can help reduce concentration risk.
Do you have an emergency cash buffer?
A market crash becomes much more painful when you need to sell shares to cover an unexpected expense.
Keeping an emergency fund outside your investment portfolio can provide breathing room. It means you're less likely to be forced into selling quality ASX shares simply because you suddenly need cash.
Will you be ready to buy?
A crash isn't necessarily just a threat. It can also create opportunities.
When fear dominates the market, excellent businesses can sometimes become available at substantially lower prices. But taking advantage of those opportunities requires capital.
If every dollar is already invested, investors may have little flexibility when attractive ASX shares go on sale.
Foolish takeaway
Nobody knows when the next crash will arrive or how severe it will be.
That's why I don't think predicting it is the most productive goal. Instead, I'm focusing on knowing my risk tolerance, maintaining sensible diversification, keeping an emergency cash buffer and having a plan for deploying capital.
The goal isn't to predict the crash. It's to make sure you're ready when it comes.
