How To Protect Your Wealth From A Market Crash

One of the great fears, if not the greatest for stock market investors, is that a large portion of their capital will be wiped out in a stock market “crash”. This fear of losing it all is a primary reason why so many investors lose out in the stock market by “buying high and selling ow”. It is difficult, if not impossible, to accurately predict large market drops. They almost always come as a surprise. The only way to manage your stock portfolio in regards to market drops is to understand what they are and what will happen when stock prices take a tumble.

Definitions to Know

Stock market participants and watchers have developed criteria for what are commonly referred to as a market correction and a bear market.

A stock market correction has happened when the major stock market indexes have declined by more than 10% from a previous high. Historically, the stock market has experienced a correction every 18 to 24 months.

A Bear Market is defined as a stock market drop of greater than 20%. In function, most bear markets have produced declines of 30% to 50% below the peak starting point. Depending how you time the cut-offs, the U.S. stock market has experienced 7 to 10 bear markets since the Big One in 1929-1932. The length of a bear market is measured in months, with an average length of about 18 months.

Bull Markets are the period between the bottom of one bear market and the start of the next. Historically, bull markets have gone on for years, with 10-year plus upswings more common than not. The current bull market is in its 6th year.

You can also have corrections and bear markets in individual sectors of the market or economy. For example, the energy sector of the S&P 500 dropped by 30% from its June 2014 peak to the January 2015 bottom.

There is no firm definition for a market crash. To me, a crash in the current economy is a really fast moving bear market. Crude oil crashed in the fourth quarter of 2014. The only real, wealth wiping crash to date was the 1929-1932 wipe out associated with the Great Depression. The use of the word crash in the financial media and the marketing of financial products is mostly just a scare tactic.

What You Really Need to Know

No one that I know of can accurately predict corrections or bear markets. Usually, one of these market events is well underway before we say, “Crap, this stinks and I am losing money!” First and foremost you must tell yourself that these market drops are always temporary and prices will recover.

In a market correction, everything is going down. When all of your stocks are dropping it is not that they have become bad investments. It’s that fear in the market is causing investors to sell everything. It’s when you have a stock going down and everything else is up that you need to take a closer look at that stock.

Fear drives a bear market. You will feel it. I will feel it. The investors that come out the other side are the ones who don’t give in to the fear and sell when share prices are down. If you have cash available, you should think seriously of adding to your best stocks. Remember that in a bear market, the sellers don’t differentiate between good and bad companies.

Over the longer term, the stock market drops from corrections and bear markets disappear into the general long term trend of higher values. In history, the market always comes back to exceed its previous highs. It may take years, but the market will come back. In the most recent bull market, the S&P 500 peaked in October 2007, the bottom of the bear market happened in March 2009, and the index passed the previous peak in March 2013. Now the S&P 500 is 35% above the 2007 peak.

The Current Situation

Historically, two-thirds of bear markets are associated with recessions in the economy. Although current economic growth is slow, there are no signs of a pending reversal of growth or any bubble in  the  markets that could trigger a stock market sell-off. At this point, the only thing I see as a cause of a new bear market would be a correction that turns into a bear when the fear gets out of control.

On a strictly timing criteria the stock market is overdue for a correction. The last correction occurred in November 2011, 3 1/2 years ago. A correction at some point in 2015 would not be a surprise. The stock market needs the occasional correction to remind the investing public that investing is stocks is not an always going up, no-brainer decision. However, corrections quickly disappear into the gains of an ongoing bull market, as illustrated by this graphic of the 2011 correction and the market to date.