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How to Prepare for a Market Crash

The China-based Shanghai Stock Exchange Composite Index is down 6.2% today (at the time of writing; 3:02 pm). At the moment, the index has fallen by a third from a June peak.

As sure as night follows day, there may come a time when the Singapore stock market experiences its own form of such extreme stock market turbulence. (Side note: Our market barometer the Straits Times Index (SGX: ^STI) is down by 1.4% to 3,293 points as I write, but at that level, it’s only a 7.2% decline from its 52-week high of 3,550.) But crucially, nobody knows when.

When a stock market crash does happen, we may want to be prepared to pick up bargains. After all, fortune favors the prepared. And to prepare for a stock market crash, there may be some steps that Foolish investors can take.

Cash, cash, cash

Having cash on hand to deploy in the stock market would be handy during downturns. But it’s important to make clear distinctions between the types of cash you have:

  1. Emergency cash: This would be the cash that keeps you financially afloat in unexpected circumstances such as the loss of a job (touch wood!) or a hair-cut gone wrong. This would also be a separate pot of cash to the one you invest with.
  2. Cash cushion: Now, this would be the cash you’ve put aside for bargain hunting when stocks fall. The presence of this cash may also help keep your wits about you as well (it certainly does for me).

Investing is as much psychological as it is numerical, so if you are worried that you won’t be able to meet your next rental or mortgage payment – your state of mind may not be favorable for rational investing. This underscores the importance of having the emergency cash pile.

Keeping a watch-list

As the old adage goes, we should prepare an umbrella before it rains.

If we choose to only start studying stocks after the stock market crashes, we may make the job of sifting out bargains that much harder; trying to familiarize ourselves with companies under turbulent stock market conditions adds unnecessary complexity to the task.

That’s why it can be useful for us to have done most of the research first when market conditions are a lot more benign.

As examples of areas where you might find more bang for the buck in your research efforts, companies that have a history of resilient earnings –  such as Raffles Medical Group Ltd (SGX: R01)Dairy Farm International Holdings Ltd (SGX: D01) and ARA Asset Management Ltd (SGX: D1R) – may be a good place to start.

All said and done, it’s better for us to start studying companies and building our own watchlists sooner rather than later.

Cash deployment plan

“Everyone has a plan until they get punched in the face” – Mike Tyson

Stock market crashes may be tougher to manage than we think.

As such, designing a plan on how you deploy your capital (or cash cushion) in the event of a market crash could be one way to moderate your own behaviour. Everyone’s personal circumstances will be different, but my U.S. colleague Morgan Housel has some useful food for thought in terms of coming up with a plan to put capital to work.

In a previous article, he had looked at the U.S. stock market’s history going back to 1928 and figured out the frequency and magnitude of declines in stocks there.

With such data, Morgan then came up with a loose plan on how he might deploy his capital, assuming he had set aside a $1,000 cash cushion and keeping in mind the idea that he wants to take the greatest advantage of crashes that are both severe as well as historically frequent. The table below, which comes directly from him, shows his findings:

Cash deployment table

Source: Morgan Housel, Fool.com

At the local front, the Straits Times Index is currently trading at around 7.2% below its 52-week high as mentioned earlier. Tracking the movements of the index could be one way we can think about the rate at which we deploy our cash cushion, like what Morgan has done with the U.S. market.

A Fool’s take

To be sure, none of the above is meant to be a signal to exit the stock market.

As my local colleague Chong Ser Jing has pointed out barely two months ago, the Straits Times Index could still be trading at a discount to its historical valuation ranges.

On a personal note, 85% of my portfolio is invested (meaning to say I have a 15% cash cushion) and unless a personal need arises or an investment thesis changes, I don’t plan to sell for decades to come.

After all, it’s in holding great companies for the long-term through thick and thin that may reward us the most.

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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 Chin Hui Leong owns shares in Dairy Farm International Holdings and ARA Asset Management.