How To Get Ready For A Stock Market Crash
We’re in a bubble that will eventually pop
Stock market crashes tend to strike when people least expect it. People often let their guard down during the good times and pay dearly for it in the future. The V-shaped recovery in the stock market has aided the concept of better times ahead and an indestructible stock market.
Obstacles to a continued bull run include rampant inflation, declining consumer confidence, and high valuations. Unfortunately, most people take an extreme path in anticipation of a stock market crash.
The first extreme is to keep your head under the sand and do nothing. Passive investments continue growing in popularity, but keeping your hand off the wheel at all times eventually leads to accidents.
The second extreme is to sell off your assets and hoard your cash to protect yourself from the mother of all crashes. Bracing for a stock market crash involves some planning and knowing where you stand.
Your Cost Of Living
Before you make a move in the stock market, assess your financial position. How much does it cost to support your lifestyle, and does your portfolio play an important role?
If your cost of living is $3,000/mo, and you earn $4,000/mo, your portfolio isn’t vital for your cost of living. However, if you recently retired and now rely on your portfolio for paying expenses, it’s significantly more critical at the moment.
Investors will argue they can ride out a stock market crash, but in reality, not everyone can. Retirees should be more cautious while it makes more sense for younger investors to embrace a growth portfolio. Young investors have more time to ride the ups and downs, but a lack of prudence can result in financial ruin.
Since we’re on the topic, look into your cost of living and see how you can trim down your expenses. Depending on your preference, you can dip your toe in the water by ending unused subscriptions or drastically cut down on expenses
One woman lives in a boat in San Francisco for $350/mo instead of paying $3,500/mo in rent. While that living arrangement is not for everyone, drastically shaving down your cost of living will do wonders for your finances.
The less money you can live on, the more mileage you get out of every dollar that comes your way. Lifestyle deflation will help in the event your portfolio takes a hit.
Reduce Your Risk
While a stock market crash would wreak havoc on many investors, it hurts some more than others. High-growth stocks usually get hit the hardest during corrections and crashes due to lofty valuations.
Undervalued stocks fair better during corrections and crashes, but almost every stock feels downward pressure during a crash. Each investor defines risk differently, but most of those definitions boil down to a stock’s valuation and the underlying business.
Many investors consider stocks trading at 20 times their sales as overvalued (as measured by the P/S ratio). Other investors will see these types of stocks as undervalued because of potential revenue and earnings growth.
If overvalued stocks form a heavy concentration in your portfolio, look for stocks with similar growth rates and prospects but with lower valuations. Looking for alternative stocks resulted in me swapping my Fiverr shares for Digital Turbine shares.
While this isn’t as apples-to-apples as Fiverr vs. Upwork, the companies both exhibit high growth. Digital Turbine has grown faster than Fiverr in recent years and trades at 10 times its sales. For comparison, Fiverr currently trades at a 23 P/S ratio, more than twice as high as Digital Turbine.
Digital Turbine also trades at more attractive P/E, PEG, P/B levels than Fiverr while carrying a lower market cap and more robust revenue growth in recent years.
Some investors will go extreme and switch from growth stocks to bonds. However, switching from Fiverr to Digital Turbine allows you to pursue high growth at a more reasonable valuation.
I only use Fiverr vs. Digital Turbine as an example. You can disagree with these stocks or my decision. The overall concept is that you can still get growth but at a more affordable price point. If Fiverr stock drops to a reasonable level, I’ll re-enter that position.
Lower valuations leave stocks less susceptible to dramatic declines. Investors should continue monitoring their positions regardless of how much risk they remove from their portfolios.
A lower valuation isn’t always a better buy. Certain stocks look undervalued based on their ratios because of underlying problems within the business. You can look at revenue and earnings trends to get a bird’s eye view of a company’s health. Listening to the most recent earnings call will provide you with the complete picture.
Focus On Cash Flow
While cash flow producing assets garner plenty of attention during all market conditions, they become more useful during crashes. If your stocks generate cash flow, you are less likely to sell your shares. The cash flow can help cover expenses, and any reinvestments during a crash give you more shares on the dip.
Stocks can only keep up with dividends if the companies profit and continue to expand their earnings. Because of this distinction, dividend stocks are less prone to hype-level valuations. The risk surrounding dividend stocks is that if the companies get hit hard in a crash, they may suspend the dividend.
You can review a company’s payout ratio to check the dividend’s stability. A lower payout ratio indicates a safe dividend. Any stock with a dividend payout ratio above 70% requires a closer look to ensure safe payments.
The best time to get ready for a stock market crash is now. Getting prepared doesn’t necessarily mean placing numerous buy and sell orders. Instead, it means understanding how you’ll respond if the market becomes ominous and signals a potential crash.
