Market crashes – when the stock market falls by 10%, 20%, or even more – are not exactly fun events to experience or witness. But here’s the thing: They’re a natural part of the financial cycle. And, they’d always happen from time to time. It’s been more than five years since the last big market crash occurred. Are we near another one? More importantly, what should you do about it? You can’t know The first thing you have to realise about a market crash is that the markets are unpredictable. As the famous economist John Kenneth Galbraith once said:…
Market crashes – when the stock market falls by 10%, 20%, or even more – are not exactly fun events to experience or witness. But here’s the thing: They’re a natural part of the financial cycle. And, they’d always happen from time to time.
It’s been more than five years since the last big market crash occurred. Are we near another one? More importantly, what should you do about it?
You can’t know
The first thing you have to realise about a market crash is that the markets are unpredictable. As the famous economist John Kenneth Galbraith once said:
“There are two kinds of forecasters: Those who don’t know, and those who don’t know they don’t know.”
So instead of worrying and trying to predict when the next market crash will occur, we should instead focus on how we can position our portfolio to handle a market crash.
When the market crashes, there would naturally be lots of volatility. There would also naturally be investors who fear that.
If you’re one of those, there are certain types of companies which you can focus on to minimise the volatility of your portfolio.
For instance, Dairy Farm International Holdings Ltd (SGX: D01) and StarHub Ltd. (SGX: CC3) can be generally considered to be less volatile shares due to the nature of their business. The former runs supermarkets and hypermarkets across Asia while the latter provides telecommunication services in Singapore. Both are thus companies providing services or products which experience consumer demand which is not too negatively affected even by a poor economy.
The defensive nature of their shares was quite apparent during the Global Financial Crisis of 2007-09. During that period, Dairy Farm and Starhub suffered a peak-to-trough decline of around 30% and 40% respectively. Meanwhile, the general market, as represented by the Straits Times Index (SGX: ^STI) had crashed by close to two-thirds from peak-to-trough.
Handling real risks
It must be noted though, that volatility is not the same thing as real investing risk. The following is a short explanation of the idea from billionaire investor Warren Buffett:
“Finance departments believe that volatility equals risk. They want to measure risk, and they don’t know how to do it, basically. So they said volatility measures risk. I’ve often used the example of the Washington Post’s stock. When I first bought it in 1973 it had gone down almost 50%, from a valuation of the whole company of close to $170 million down to $80 million. Because it happened pretty fast, the beta of the stock had actually increased, and a professor would have told you that the company was more risky if you bought it for $80 million than if you bought it for $170 million. That’s something I’ve thought about ever since they told me that 25 years ago and I still haven’t figured it out.”
Risk to me – and to most of my colleagues here at the Motley Fool Singapore, for the matter – is the likelihood of suffering a permanent loss of my capital in any investment I make.
To lessen the chances of suffering a permanent loss of capital during a market crash, we can focus on selecting great companies that we want to be associated with for decades to come. For instance, Dairy Farm and Starhub now carry share prices which are higher than their pre-crisis peaks. The growth in their share prices were accompanied by the strengthening of their respective businesses through the years. This goes to show that, over the long-term, the share price of a company is governed by the fundamentals of its business.
Foolish Bottom Line
If the companies we own in our portfolio are great businesses which can prosper over the long-term, we’d have positioned ourselves well to handle a market crash.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.