How to Profit from a Stock Market Crash

by DR

According to Standard and Poor’s, the S&P 500 is down 40.29% for the year. And just in case you thought that was a typo, I’ll repeat myself: the S&P 500 is down forty point twenty-nine percent so far in 2008. Ouch! Now here is something that is far more important. How you handle your stock market investments during a market crash is arguably the single most important determinant of your investing performance over your lifetime. In other words, the investing decisions you make during a market crash will impact your investment returns forever. And, if you make the right decisions in a falling market, you can profit handsomely. The fact is, however, that many people lose money (and lots of it) during a stock market crash, but it does not have to be so. So lets take a look at what’s going on here, and how we can profit during this (and any) down market.

Investors are scared of the stock market

There is a simple reason why so many investors and even professional money managers are scared of the stock market–in the short term, stock prices seem arbitrary. Up one day and down the next, watching the ticker every second the market is open can cause one to wonder just what in St. Peter’s name is going on. Warren Buffett described this phenomenon like only Warren Buffett can:

In the short run, the market is a voting machine but in the long run it is a weighing machine.

Actually, Benjamin Graham first said this, and it has stuck with Mr. Buffett, who repeats it often. But the wisdom behind this statement should be taken to heart.

In the short term, stock prices reflect all kinds of noise. The Fed Chairman says this or that, and stocks fluctuate. Unemployment numbers come out, and the market reacts. A politician says something to get elected, and the stock market traders do their thing. The point is that in the short term (I’d say 1 year or less), stock prices are often the result of factors that do not bear on the long-term value of the enterprise.

When viewed long term, however, the market truly does reflect the underlying value of public companies. By long term I mean really long term (10 years or more). Stocks can be undervalued or overvalued for a decade (see 1960s or 1990s). But given enough time, stocks will reflect the underlying value of the corporation that issued the security.

Investors sell on fear and buy on greed

While most would not quarrel with the above comments, many do not take them to heart. It is not easy to hold on to your investments when they fall 40%. You start to lose confidence in your investing decisions. Then you start to wonder if there has been some seismic shift in the markets.

Remember the Internet bubble? I recall investors talking about how the world was totally different with the Internet, and they used this lie to convince themselves to buy stocks of dot com companies with zero revenue. Remember the housing bubble? Folks would tell me that they are not making any more land, so prices must keep going up. Those folks are renting now and proclaiming that owning a home is NOT the financially prudent thing to do. Oh, brother!

The point is that many investors do exactly the opposite of what they should do. When stocks are going up, they buy, buy, buy. When the markets crash, out of fear, they sell, sell, sell. All I can say is that this is wrong, wrong, wrong.

Timing the stock market is a fool’s game

I have a friend who sold all of his equity investments (a 7 if not 8 figure portfolio) earlier this year before the market crash. At a party at his house the other day, friends were congratulating him on such a wise move. So I asked him if he was going to get back into the market now. He said no. Then I asked when he was going to get back into the market. He did not know. So I reminded everybody that his decision to sell will have been a good one only if he buys at the right time, too.

Successful market timing requires you to be right twice–once when you sell, and once when you buy. And over the lifetime of an investor, you must be correct over and over and over again. Good luck.

How to profit from a stock market crash

The simple and easy way to profit from a stock market crash is to do one of the hardest things in life: nothing. “Don’t just do something, stand there!” is the best strategy, in my opinion. Of course, this assumes that your asset allocation plan is appropriate for your investing horizon and risk tolerance. It also assumes that your investments have gone down because the market has gone down, not because you invested in some silly dot com company with no revenue.

So that’s what I’ve done. I’ve not changed my asset allocation plan. I have continued to invest on a regular basis just as before. I’ve only sold one fund, and that was for tax reasons. The proceeds will be going right back into the market to maintain my asset allocation.

A side benefit of a market crash

One last thing. A market crash presents a great opportunity to determine just what your risk tolerance is. Many mutual fund companies and brokerage houses offer a short survey to help you determine your risk tolerance. The survey asks questions like what you would do if the market fell 20%. Would you sell, do nothing, or buy. Once you’ve answered these questions, the survey suggests an asset allocation based on your answers.

Those surveys are all well and good, but there is nothing like losing $10,000, or $100,000, or even $1 million to really gauge your risk tolerance. So after this market crash, you should know your risk tolerance very well. If you sold your investments over the past month or so, you make want to revisit your asset allocation plan. It may have been more risky than you can bear.

Sound money management includes investing for the long term. As difficult as it may be, this means not making investing decisions based on fear. So let’s hear how you have handled your investments during this down market.

Tagged as: standard and poor, stock market crash, stock prices, voting machine, Warren Buffett, weighing machine