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What I Plan to Do When the Market Crashes

Monday - 8/19/2013, 5:55am  ET

One of the most common questions financial TV hosts ask their guests is whether they expect a pullback or a crash to hit the market. It's an odd question, akin to asking whether they expect summer to occur. Of course summer will occur, and of course stocks will pull back. Since 1928, the S&P 500 has declined 10% or more from a recent high 89 times, or about once every 11 months, with just a handful of years escaping a 10% dip. Ten-percent pullbacks are almost as common as summers. Twenty-percent market drops have occurred 21 times since 1928, or about as often as presidential elections.

But investing is emotional and the allure of money makes us delusional, so we train ourselves to both think the market doesn't (or shouldn't) crash from time to time, and panic when it does. Few of us are immune to this, as the number of investors who claiming to be contrarians outnumber actual contrarians by orders of magnitude.

When you become resigned to the frequency of market crashes (and our tendency to panic when they hit), having an investment plan based on strict rules makes way more sense than flying by the seat of your pants and hoping you act rationally when everyone else doesn't. 

So I put together a plan to guide how I invest when the market crashes next.

Say I have $1,000 cash set aside to invest (in addition to an emergency fund). It's opportunistic money. Here's my roadmap for deploying it:

These rules apply to the portion of my portfolio that invests in broad-based stock index funds, since opportunities in specific companies and sectors vary in unpredictable ways during each crash.

Here's my thinking behind it.

I assume the larger the market drop, the bigger the opportunity to invest. I wanted to deploy enough money to take advantage of the "decent" opportunities while still having enough around for the "big" opportunities. The amount of cash deployed peaks when the market falls by 20% because that's both a large decline and a historically frequent decline. The market falling 50% represents the greatest opportunity, but it occurs infrequently enough that I don't want to earmark a ton of cash waiting for it to happen.

This is a rough guide. It doesn't take into account things like valuation. I'd likely ignore a 10% drop after a grossly overvalued market like we had in 2000. And it overlooks the fact that better opportunities may exist in bonds or real estate.

Will I follow this plan to a T? Probably not. But it got me thinking about volatility. Putting these numbers on paper forces you to think about big market drops as opportunities to exploit, rather than crises to fear. It's actually hard to think about these numbers and not want the market to crash. And most important, it provides a guide to consult when stocks do crater, based on a cool-headed analysis of history rather than an emotional reaction to the guy on TV telling me to panic.

Winston Churchill once said, "Let our advance worrying become advance thinking and planning." Wise advice to consider. 

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This article was originally published as What I Plan to Do When the Market Crasheson Fool.com

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