Drop It Like It’s Hot: If a Market Crash Is Coming, Should I Sell My Stocks?

Drop It Like It’s Hot: If a Market Crash Is Coming, Should I Sell My Stocks?

Selling off all your stocks in a premature panic is rarely a good idea. Here's what to do instead.

Drop It Like It’s Hot: If a Market Crash Is Coming, Should I Sell My Stocks?
Stock Trading

Stock Trading

Real Estate

Real Estate

Beginners

Beginners

"Never try to catch a falling knife" is a common saying amongst stock traders. It advises against buying a stock while its price is plummeting, hoping that you'll get in before a rebound. But what about when your stocks are shooting upward, and you're worried about flying too close to the sun? Should you sell your stocks then?

The thought of a pending market crash might tempt you to pull out of the market completely, but going all-in or all-out is rarely a wise choice.

Selling off your stocks and holding onto cash will protect your assets against volatility, but it will also cost you in two ways: inflation cost, and opportunity cost.

  • Inflation: Inflation causes the value of the dollar to diminish over time. Even if you earn interest on your savings with a high-yield savings account, you're not earning enough to protect your money against inflation.
  • Opportunity: When you take your money out of the market, you're not just avoiding loss. You're also missing out on any gains you could've earned during that time.

To succeed in profiting from a big sell-off, you're actually attempting to time the market twice—you need to know when it will drop (so you can sell right beforehand) and when it will recover (so you can buy back at the right time). Unfortunately, it's impossible to predict the market like that. Even armed with ample knowledge and investment experience, the best you can do is make an educated guess. Are you willing to take such an extreme position based on an educated guess?

Missing even one day of tremendous gains in the stock market could set you back months, or even years. For example, if you invested $10,000 in the S&P 500 in 2005 and then never touched it again, you'd have $41,100 by 2020. If you'd decided to take your money out of the market now and then to avoid a dip, and you missed just 10 of the best market days during that 15 year time period, you'd only have $18,829 by 2020. That attempt at timing the market cost you over $22,000.

Trying to time the market might not be the best choice for most people, but that doesn't necessarily mean you should do nothing. You can still lower your risk and exposure to the market by rebalancing and diversifying. Before you decide on the best course of action, though, consider your current financial circumstances.

Assess your situation apart from market conditions

Are you nearing retirement age? Your time horizon is one of the most important factors in determining your risk tolerance. If you've still got 15 or 20 years before you'll need to access the money you've tied up in investments, you've got time to weather a hit to your portfolio and bounce back. However, if you're planning to retire in the next few years, a market downturn could leave you with significantly less money to retire on than you expected. In this case, you might want to decrease your exposure to more volatile assets like stocks.

Are you behind or ahead on your investing goals? If you've managed to sock away a lot more than you planned, or you've earned higher returns than expected, you might already be on track to retire with 2x what you'd actually need to maintain your current lifestyle. If that's the case, you don't necessarily need to go for growth. Instead, you could focus on preserving your gains by allocating your assets less aggressively. This might mean shifting from growth stocks to value stocks or allocating more of your assets toward bonds.

Will you need to access that money soon? If there's a chance you'll need to access the funds in your investment accounts within the next few years, whether that's because you've got your emergency fund stashed away in stocks or you've been investing your down payment for a house, it might be a good idea to put some or all of that money in a guaranteed investment such as a high-yield savings account or a certificate of deposit (CD).

Rebalance your portfolio

If you're investing for the long-term you want to avoid checking your accounts every day and moving around your money too often. However, it does make sense to rebalance your portfolio every so often, especially when major shifts have occurred.

Rebalancing is the process of shifting assets around in your portfolio to make sure each one still holds an appropriate weight. Let's say you're 20 years out from retirement, and you decided to put 60% of your assets in stocks, 15% in real estate, 15% in bonds, 5% in startups, and 5% in cryptocurrency. However, your stocks have been performing exceptionally well in the past year, netting you higher returns than expected. Your portfolio balance has shifted, and you now have 75% of your assets in stocks. In this case, you'll want to sell off some stocks and use the money to buy other assets according to your allocation goals.

As you near retirement age, it becomes even more important to make sure your portfolio isn't too aggressive. You can shift away from growth stocks, which tend to be riskier, toward value stocks, which tend to outperform during market downturns. If you've become stock-heavy, you can sell some stocks to dial back your exposure to the market. You can then use that money to invest in lower volatility assets like fixed annuities and treasury bonds that help you focus on capital preservation.

Diversify your asset allocation

In addition to making sure your portfolio is appropriately balanced, you can also use diversification to protect yourself against a market crash.

You can diversify within your stock portfolio by making sure you hold stocks in a variety of different sectors. But it's also wise to invest outside of the market in uncorrelated assets. These assets don't track the same patterns as the stock market, so they stand a greater chance of continuing to perform even when the market is down.

Treasury bonds have historically been negatively correlated with the stock market, which means they tend to move in the opposite direction from stocks. This makes them an excellent asset for preserving capital, but not great for growth. 

Some alternative assets—that is, assets other than stocks and bonds—have been uncorrelated to the stock market and provided decent growth potential. For example, farmland tends to be a very stable asset (after all, we always need to eat, even during a recession) while historically offering returns that are comparable to the stock market. Real estate is another asset that's less volatile but still offers generous returns.

While it might be risky to sell off stocks and buy a rental property or farmland, there are safer and easier ways to diversify into these asset classes. For example, you can invest in real estate investment trusts (REITs). These are baskets of real estate assets that you can buy shares in similar to how you buy shares in a company on the stock market. Investing app FarmTogether lets you invest in US farms that are operating and often already generating income.

farmtogether

FarmTogether

5.0

Farmland

If you're still worried, you can prepare by…

Ultimately, you shouldn't sell your stocks unless you have evidence they're no longer a good long-term investment (perhaps the fundamentals of a company you hold no longer support its rapidly increasing price) or you have the opportunity to invest in something else you're sure will produce greater long-term returns.

Otherwise, it's best to protect yourself from market corrections and market crashes by regularly rebalancing your portfolio and diversifying your asset allocation.

You can also prepare your finances by saving up a healthy emergency fund (at least 3 to 6 months of living expenses) and paying off debt (especially high-interest debt) to lower your monthly financial burden. Once you've freed up some cash flow, you can pad your savings for additional protection.

Whatever you do, make sure your decisions are based on real data and solid fundamentals rather than panic and fear.

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