Investing in the stock market gives you an opportunity to grow your money. By investing wisely in shares of individual companies or in funds that track the performance of a specific industry or the whole market, you'll have the opportunity to earn a return on investment that few other assets offer.
But when you're deciding how to invest money, you need to be aware that there are risks. And, during times of economic uncertainty (like a global coronavirus pandemic), that risk can be even greater as there's likely to be more movement in the market. That doesn't mean you should steer clear of investing during a recession, but you do need to be aware of the smart money moves to make in a volatile market and be prepared in case of a stock market crash.
Fortunately, following these 12 steps will help you make sure you don't suffer outsized losses in the event the stock market performs poorly when you have money invested in it.
The definition of a stock market crash
A stock market crash occurs when there's a sudden, sharp decline in the value of indexes that are used to measure the performance of the market as a whole. For example, the S&P 500 is a stock market index that measures the prices of 500 of the largest U.S. companies. If the price of the S&P 500 falls sharply, that's considered a crash. The Dow Jones Industrial Average is considered another indicator.
There's no one accepted definition of exactly how sharply stock prices have to fall in order for a crash to happen. A market correction is generally considered to occur when the market falls more than 10% but less than 20% from its 52-week high (the highest price it hit over the past year). And if the market drops more than 20% off the recent high, that's generally considered a bear market.
Sometimes a down market can last a long time, like the Great Depression or Great Recession, and other times it can last just a few months. Generally, a bear market is considered a time of prolonged stock market decline, and it is the opposite of a bull market. A market crash, however, usually has to do with how quickly share prices fall. If share prices tumble quickly and unexpectedly, investors refer to it as a crash.
12 things to do when the stock market crashes
Whatever the specific definition of a market crash, it's no fun when one occurs and you have your personal finances invested. After all, you could see your portfolio value drop by a huge percentage in the blink of an eye.
The important thing to remember is that market crashes are part of natural market cycles and they don't necessarily mean your money is gone forever. It's important that you don't panic during market downturns.
Instead, you need to be smart about how you react to volatility on Wall Street, and you can do that by following these 12 steps.
1. Familiarize yourself with your own portfolio
When the market is going up, it's common to get complacent about your investments. In fact, many people don't even remember what stocks or funds they own — especially if they're using a robo-advisor or they picked funds when they signed up for a 401(k). This can also happen if you simply picked a plan based on your risk tolerance when signing up for a brokerage account.
During a crash, it's a good idea to take a look at what assets you've put your money into. Is your money in exchange-traded funds (ETFs) or mutual funds? Which asset classes are part of your investment portfolio? Do you have money in cryptocurrency like Bitcoin or in precious metals? Knowing these things helps you to decide whether you're happy with your investing strategy or if you need to make any changes going forward.
2. Diversify, if you haven’t already
One of the best ways to minimize the risks of losing everything in a market crash is to make sure your money is spread around in a mix of different assets. That's called diversification.
If you've invested in a target-date fund (one that allocates your investment dollars to different assets based on your timeline for using the money), then your portfolio is already diversified for you. But if you've invested in stock shares of individual companies or many other types of funds, you may not have the diversity you want to stay safe.
You'll want to both have exposure to some assets besides stocks (such as bonds or real estate) and make sure the money you have in the stock market is invested in all different kinds of companies. If your assets are too concentrated in any one specific type of investment, a market crash can be a wake-up call to change that.
3. Remind yourself of your risk tolerance
Taking the risk of some losses is a key part of any investment strategy, but you need to determine how much risk you're comfortable with. That's known as your risk tolerance.
Hopefully, when you first started investing, you made a careful assessment of your tolerance either by talking with a financial advisor or by answering a questionnaire if you use an online investing platform.
If you invested based on your risk tolerance, you hopefully put an appropriate percentage of your portfolio into the stock market and some into other assets. If that's the case, you've already planned for the possibility of a market downturn and made the best investment decision you could about what percent of your assets you expose to the biggest market fluctuations.
4. Get ready to buy
When the market crashes, the share prices of many stocks fall because investors are afraid — but not necessarily because there's anything wrong with the companies. That means shares are essentially on sale and you may be able to buy them at a bargain price. In fact, it can actually be a good idea to buy stocks when the market is crashing even if your first inclination is to sell off.
Although buying during a downturn makes sense, it can be hard to know how far down the market will go or how long a bear market will last. That's what makes a technique called dollar-cost averaging such an effective way to buy stocks.
With dollar-cost averaging, you regularly put the same amount of money into an investment on a set schedule. For example, you could buy $100 worth of an S&P 500 index fund every week. When the market is down and your fund is at a lower price, you get more for that $100. When you follow your schedule, you're sure to buy at least some shares at very low prices.
5. Avoid trading on margin
When you trade on margin, you borrow from your brokerage with your existing stock balance acting as collateral. With a margin account, you’re able to leverage your securities to buy more.
However, trading on margin always increases your risk because you're buying assets with borrowed money. Trading on margin is especially dangerous when the stock market is volatile or after a crash happens because the value of your securities that are guaranteeing your loan could also fall.
A brokerage will require you to maintain a specific percentage of equity in your account when you trade on margin. If the value of your assets falls below the accepted level, you'll get a margin call and have to either add cash or securities to your account. If you don't, your brokerage can act on its own to sell your stocks — possibly locking in losses. This is why it’s generally recommended for those new to the stock market to avoid trading on margin during volatile times.
6. Resist the urge to sell
If you see the next stock market crash start to happen, your emotions may trick you into selling your shares ASAP to avoid further losses. This is known as panic selling, and it’s a good idea to resist this urge.
If you've picked good stocks or index funds to invest in, the downturn should be temporary and your portfolio should recover. But if you sell during a crash, you could take a loss and you'd be giving up the possibility of that recovery happening.
7. Rebalance after the dust settles
Sometimes, even when you start with a diversified portfolio and assets that match your risk tolerance, your portfolio ends up out of balance. Say, for example, you wanted to be 80% invested in stocks so you put $80 into the market and $20 into bonds.
If your stocks outperform and your bonds underperform and you end up owning $90 worth of stocks and $10 worth of bonds, you're now at a 90% to 10% asset allocation. You should rebalance to get your asset allocation back on track with your intended investment strategy as soon as the market volatility calms down.
8. Consider doing nothing
If you aren't comfortable increasing your stock purchases and don't want to take a chance of rebalancing at the wrong time, your best bet may be to simply sit on the sidelines for the short term and wait things out. That way, you won't make a mistake based on heightened emotions caused by the crash and you can reassess with a clear head later when the markets calm down.
9. Talk to a professional
Financial professionals can provide guidance on whether your portfolio has the right asset allocation, whether you're properly diversified, and the best way for you to respond to a financial crisis.
If you're really lost about how to handle your money in a bear market, it can be worth reaching out to a registered investment advisor or other credentialed expert to find out your best moves to make.
10. Consider a Roth IRA conversion
If you've invested money in a traditional individual retirement account (IRA), you got a tax break when you contributed but when you retire you'll have to pay taxes on the money you take out of that account. A Roth IRA, on the other hand, requires you to pay taxes on your contributions, but lets you take money out tax-free. If you want to avoid taxes as a retiree, it sometimes makes sense to convert your traditional IRA to a Roth IRA.
If you're thinking about doing a conversion, you're going to be taxed by the IRS on the converted funds. If your account balance has fallen during the market crash, you may want to take the opportunity to do the conversion now when your portfolio balance is down. That way, you'll be taxed on a lower amount so your IRS bill won't be as big. In this way, a market downturn can be a good thing for your retirement planning.
11. Take advantage of tax-loss harvesting
If you have investments outside of a retirement account (like a 401(k) or an IRA), selling stock can have tax consequences. If you sell at a profit, you have to pay capital gains taxes. But if you sell losing investments, you can offset your gains.
Say, for example, you made a $5,000 profit on one stock you sold, but you lost $1,000 on another stock. If you sell the losing stock, you could deduct the loss from the gains and pay capital gains tax only on $4,000.
Timing the sale of losing investments to offset losses is called tax-loss harvesting. It can be a complicated strategy and there are some rules to follow, but it's worth considering if the market crashes. Some robo-advisors offer automatic tax-loss harvesting for you, or you could talk with an account or investment advisor to find out if it's a good idea.
12. Bulk up your emergency fund
Finally, bulking up your emergency fund is another smart step you can take. This may not seem like it belongs on a list of what to do when the market crashes, but your emergency fund can help protect your investments. If you have money saved for financial emergencies, you won't have to sell investments to cover surprise expenses if something goes wrong.
When the market is up, make sure to put that money in one of the best savings accounts, as these will have better interest rates so you're at least making a little money on your savings.
No one likes to live through a market crash, correction, or bear market. Of course, whether you're investing in a recession or during good times, there's always a chance a sudden crash will occur. The good news for long-term investors is, you don't have to lose your money in a market crash — and you might just end up coming out better off if you follow these smart steps to prepare for and respond to a market crash.