What Would You Do When The Stock Market Crashes?

It wasn’t too long ago when stocks in Singapore were mauled by a bear market, defined as a market in which stocks fall by more than 20% from a recent high.

At its lowest, which was reached on 29 September 2015, the Straits Times Index (SGX: ^STI) was 22.8% below this year’s peak of 3,550 that it had touched merely months ago on 16 April.

How fast things have changed.

At its current level of 3,020, the index has experienced a 10.2% rebound from its recent low. Although there’s still a long way to go before the April-peak can be breached, this is still a welcome respite for investors. Thing is, is the rebound just a dead-cat bounce, a brief break before a more brutal decline takes hold?

I don’t know the answer. I don’t think anybody knows either. Stocks are bound to crash hard from time to time – we just don’t know when.

But, let’s pretend the market has just crashed big. Would you sell all your stocks? Or would you see it as an opportunity for bargain hunting? I don’t think anyone would say they belong to the former camp. The sad reality however, is that most of us will likely be. As my colleague Morgan Housel once wrote in a Wall Street Journal piece:

“Few investors will admit they will panic and sell after stocks decline. They are more likely to tell you that any decline is an opportunity to buy cheap shares.

But the reason stocks decline is specifically because panic sellers outnumber opportunistic buyers. Everyone wants to think he or she is a contrarian investor, but, by definition, most can’t be.”

This highlights a very important aspect of investing – having a plan. Most cannot imagine how horrible – to the extent that rational decision-making becomes near impossible – it’d feel when an actual crash happens only until one actually does hit. I was reminded of that in a recent tweet by investment manager, author, and blogger, Ben Carlson, describing the experience of an investor who had lived through the infamous Black Monday, a time when stocks in the US tanked by more than 20% in a single day:

Tiding over a crash looks easy on hindsight, but things feel very different in the here-and-now. As such, it’s good to at least have a rough idea of what to do if and when the market crashes. Here’s some food for thought.

How to deploy capital

Morgan once studied over 100 years of market data in the US to find out how often the stock market has fallen by a certain amount. The idea of doing so is for him to have a gauge on what percentage of his cash cushion in his portfolio he should invest when the market falls, taking into account both the frequency and severity of the declines.

This is what he came up with:

Plan for stock market crash

Source: Morgan Housel;

The table above is Morgan’s individual plan and is also based only on the history of the American stock market. Different people living in other countries would naturally have different circumstances to deal with, so it’s worth noting that Morgan’s plan is not meant to be a universal prescription.

Have a wish list

A wish list is made up of stocks you’d like to buy, but only at lower prices. The late Sir John Templeton, a legendary investor who achieved a compound annual return of nearly 16% over 38 years from 1954 to 1992, is famous for having a wish list.

Here’s what Templeton’s niece, Lauren Templeton, had to say about the wish list in the book Investing the Templeton Way:

“No matter how much investors want to distinguish themselves in these tough moments [referring to market downturns], there are psychological challenges to maintaining a clear head during a sharp sell-off…

…One way Uncle John used to handle this was to make his buy decisions well before a sell-off occurred. During his years managing the Templeton Funds, he always kept a “wish list” of securities representing companies that he believed were well run but priced too high in the market…

…Taking this a step further, he often had standing orders with his brokers to purchase those wish list stocks if for some reason the market sold off enough to drag down their prices to levels at which he considered them a bargain.”

Templeton recognised how difficult it can be to make rational decisions during market declines and so, made his buy-decisions way in advance during times when the market was calm.

A Fool’s take

Mike Tyson once said that “Everyone has a plan ‘till they get punched in the mouth.” So, having a plan isn’t the end of it – we must also have the tenacity and discipline to stick to it, especially when the going gets tough.

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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 writer Chong Ser Jing doesn't own shares in any company mentioned.