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Beating a market crash

2018-10-24, Michael Thompson

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Beating a market crash

At the time of this writing the S&P 500 has lost over 9% of its value in the last month (3% today alone). Many people are asking if they need to sell to avoid further losses. A few are asking if they should buy more stock, believing these are discount prices. What’s the right action?

Most experts I trust think a major crash, within a year, is very unlikely. They believe stock market performance for the next several years will not be as good as the last several years but think there’s no more reason to buy or sell than there was a month or a year ago – the current value of the market has mostly accounted for future expectations. However, there is a psychological factor that’s good to realize in a time like this.

Let’s say company A releases bad news. It lost a huge customer and the long-term affect is a 10% decline in the stock price, from $1 to $0.90 per share. Over a period (often starting before the news release!) the stock drops, say $1 to $0.95. As shareholders hear the news and notice the downward price trend many “panic sell” to avoid further losses. The problem is that this behavior feeds on itself – as the price drops below $0.90 more people panic sell, causing the price to drop further, causing even more people to sell, …. As the price falls the stock becomes more attractive to other investors at a rate which increases with lower prices. At some point, say $0.80, the buyers finally overpower the sellers and the price rises. The panic eventually ceases, the price climbs further, and often overshoots $0.90. Further up/down fluctuations often occur while the price converges to $0.90. Longer term the average company will increase in value and the stock will recover to $1 and well beyond. Accurately timing these events is difficult to impossible – I’ve never seen anyone do it consistently.

The flip side of this is that prices will also overreact to good news. Prices often soar too high as many investors develop a fear of missing out (FOMO) on a big rally. Eventually sellers take over and drive the price back down to reality. In fact, there are many people who lose big money buying in (high) on rallies and selling (low) after bad news reports.

How does this apply to the market today? Should we sell stocks to avoid further losses? Has the market already overcorrected? Unfortunately, I don’t think you or I will be able to figure this out with any certainty. The market may have already “over dipped” or maybe this is only the beginning of a much larger decline. The main takeaway here is that, if you bought into the market for a long-term investment, it’s probably best to stick with your long-term plan. Eventually the market should recover, and longer-term prices should rise indefinitely. Changing plans now and trying to time the market will likely do more harm than good (and it will cost more of your time and focus).

Other facts from experts

Charlie Munger (Vice Chairman, Berkshire Hathaway)

Historically markets have dropped 30% every decade or so, and 50% more than once a century. If you can't hold on for this rollercoaster ride, consider holding a higher percentage of less volatile assets (and accepting smaller long-term returns). Read more about this here.

MarketWatch Analysis

This analysis from MarketWatch indicates that, at least in the last two crashes, you'd be much better off selling early and slowly rebuying your positions over time. Of course, you'd still need to time your selling decently – if you sell too early many of your repurchases will end up at higher prices.

The Motley Fool

This article recommends preparing for a crash by holding some cash and building a watch list of stocks you'd like to purchase when cheap enough. They also recommend holding defensive stocks. This is somewhat like Warren Buffett's strategy. Of course, this too requires some timing – holding excess cash and defensive stocks in "good times" will kill your returns.

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