Have you ever heard of the well-known financial-world adage ‘Sell in May and go away’? It is based on the historical underperformance of some stocks in the “summery” six-month period commencing in May and ending in October, compared to the “wintery” six-month period from November to April. If an investor follows this strategy, they would divest their equity holdings in May (or at least, the late spring) and invest again in November (or the mid-autumn).
Despite the above saying, it has been a lot of noise lately in the various financial news sites, warning about a potential stock market crush. The first thing you need to do as a stock market trader or investor is to keep calm, because there are several ways in which you can take advantage of a stock market crash, like many people did on March 2020.
The powerful truth often repeated in financial circles is that making a lot of money doesn’t require a high IQ, either in the market or in business. It takes ruthless cost control, a disciplined routine, and a focus on doing what is right for the long term. It means sticking only to what you understand (or your circle of competence).
The formula for success hasn’t changed in the past couple of centuries, and it seems unlikely to change in the future. Here are five rules for making money during a stock market crash.
The only sure thing in life, and especially in investments, is that there is no such thing as ‘risk free’ investment.
There is a concern lately between investors, that a stock market crush is approaching in the near term. Some stocks can be considered as largely overvalued right now and unfortunately; we see a correction a huge selloff on Tech stocks lately. Throw in an ongoing pandemic and shaky economy, and it’s easy to see why some investors may be nervous.
Here we will walk you through eight important investment strategies and mindsets to help you stay calm and play dead when the stock market takes a swipe at your returns.
Always maintain some liquidity
One of the most important investment strategy which will help you get through a stock market crash is having available cash. According to Warren Buffett, liquidity has been central to how he has managed to jump at opportunities when they arise.
In 2011, he told a story about his grandfather Ernest, who taught him the importance of always having at least $1 000 cash on hand, and he explains how he still applies the principle – albeit on a much larger scale. “We customarily keep at least $20 billion on hand so that we can both withstand unprecedented insurance losses and quickly seize acquisition or investment opportunities, even during times of financial turmoil.”
In 2012, he stressed the point again, saying: “Charlie and I believe in operating with many redundant layers of liquidity, and we avoid any sort of obligation that could drain our cash in a material way. That reduces our returns in 99 years out of 100. But we will survive in the 100th while many others fail. And we will sleep well in all 100.”
Being able to sleep soundly is a recurring theme. In 2009 he tells shareholders: “I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”
Don’t follow the crowd
One of my favorite Warren Buffett’s sayings is : ‘Be fearful when others are greedy and greedy when others are fearful’. Therefore, you shouldn’t be swayed by what others are doing or saying. You should follow your own way of investing and not buy and sell driven by media or analysts commentary.
As humans, we follow the herd mentality where a hint of fear in the herd sends wave of panic in the entire herd, forcing them to get out of the situation and bail out to safety. Investing in stock market is no different as it is also a reflection of our collective actions.
The moment we sense a danger, a panic takes over the market, and a selling spree starts. Everything, good or bad gets sold, pushing the stock prices down, irrespective of its underlying fundamentals.
Your job as a rational investor is not to panic, but to revisit the fundamentals and valuation of the stocks you own or want to own in the future.
Investors frequently sell low in times of financial crisis, largely because of the psychological need to follow the herd. Contrarians like Buffett use the opportunity to buy quality stocks from that herd.
“Stock market is a great machine to transfer money from the impatient to the patient.” -Warren Buffett
Have a well-diversified portfolio
A diversified portfolio could be your ticket to surviving a stock market crash. Your investment mix should, ideally, include stocks from a variety of market sectors — healthcare, tech, banks, automobiles, and energy, just to name a few. You can achieve this by hand-picking individual stocks yourself, or by loading up on index funds or exchange-traded funds, which allow you to own a bucket of stocks with a single investment.
Having a percentage of your portfolio spread among stocks, bonds, cash, and alternative assets is the core of diversification. How you slice up your portfolio depends on your risk tolerance, time horizon, goals, etc. Every investor’s situation is different. A proper asset allocation strategy will allow you to avoid the potentially negative effects resulting from placing all your eggs in one basket.
Take stocks in defensive industries
It is well-known that defensive or non-cyclical stocks are securities that generally perform better than the overall market during bad times. These types of stocks provide a consistent dividend and stable earnings, regardless of the state of the overall market. Companies that produce household non-durables—such as toothpaste, shampoo, and shaving cream—are examples of defensive industries because people will still use these items in hard times.
Find buy opportunities in the market
In bear markets you can find the great opportunities and we have seen that in every past market crash. The trick is to know what you are looking for. Beaten up, battered, underpriced: these are all descriptions of stocks during a bear market. Value investors such as Warren Buffett often view bear markets as buying opportunities because the valuations of good companies get hammered down along with the poor companies and sit at very attractive valuations. Buffett often builds up his position in some of his favorite stocks during less-than-cheery times in the market because he knows the market’s nature is to punish even good companies by more than they deserve.
Buy shares of good businesses that generate real profits and attractive returns on equity, have low-to-moderate debt-to-equity ratios, improve gross profit margins, have shareholder-friendly management, and have at least some franchise value.
Markets behave irrationally, at times they are overly optimistic and other times they are highly pessimistic. A rational investor takes advantage of such irrational behavior to find great investment opportunities in the market.
Every stock has a business behind it, which, in the long term, determines the price of the stock. If the business performs well, the stock price will eventually appreciate accordingly.
When the stock market crash, all the stocks also crash, irrespective of their size or quality of their underlying business. What is interesting is, while the prices of such stocks correct significantly, the underlying quality of the business largely remains unchanged.
Such situations present a great opportunity for long term investors to buy great quality stocks at a bargained price, thus turning a market crash into a money-making opportunity.
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