It's not unreasonable to be worried about a stock market crash. Imagine being invested in the market in 1987 and seeing the Dow Jones Industrial Average plunge in value by nearly 22% in a single day. Or watching the Nasdaq Composite Index crater by more than 76% between 2001 and 2002. Such events dealt major blows to countless portfolios.
There are good reasons not to worry about stock market crashes, though -- especially if you can avoid some common blunders. Here are five mistakes to avoid.
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1. Focusing on the short term
Don't have a short-term focus. Money you expect to need within five years (if not 10, to be more conservative) shouldn't be in the stock market in the first place. Stock market crashes do happen now and then, and you don't want to have to sell shares when they've fallen sharply.
Having a longer-term focus can help you wait out a crash until the market recovers, which it often does within only a few months. Indeed, the average stock market drop takes about six months before changing direction -- and most take less than four months. (Of course, sometimes it may take years.)
2. Selling out of the market
One mistake many make when the market crashes is selling out of it. They're doing the opposite of the old investment chestnut to "buy low, sell high." If your portfolio plunges by, say, 30%, you haven't technically lost any money until you sell your shares and lock in that decline. Hang on and you'll often be able to sell later, at a significantly higher price.
One of the most important traits you can have if you want to be a terrific investor is patience. Expect the stock market to crash now and then, and plan to wait it out. Motley Fool co-founder and CEO Tom Gardner has noted that the stock market ends up in the red in about one out of every three years, with the extent of those drops varying considerably. It pulls back by up to 10% roughly annually, and by around 20% every four or five years. Drops of 30% to 40% or more are much more rare, occurring every 10 or more years, respectively. Keep in mind, of course, that the market has recovered from every one of its past declines eventually -- so selling out of it out of worry or panic is not a productive move.
3. Putting off investing in the stock market
Putting off investing in the market is also a regrettable move, because the best time to invest in stocks is often right now. If you have funds available to invest for the long term and you've read up on stock investing enough to have confidence in your actions, then it's probably best to just invest. Trying to time the market is usually a losing proposition, as no one knows what the market will do from month to month or year to year -- though its long-term trajectory has always been up.
4. Being underdiversified
A market crash can hit you harder if you happen to be invested disproportionately in stocks or industries that fall the most sharply -- like Internet-based businesses in the dot-com bubble of 1999-2000 or financial services companies in the financial crisis of 2008.
Aim to keep your portfolio reasonably diversified by spreading your dollars across many different companies and industries. Our Foolish investing philosophy suggests buying into around 25 or more companies and aiming to hang on to your shares for at least five years. Doing so will reduce the risk of one of them imploding and taking your portfolio down with it, and will also give promising businesses time to perform well and see their shares rise.
5. Not preparing to bargain-hunt
Finally, this last mistake is one of omission rather than commission: not being ready to go shopping when the stock market tanks. Don't keep all your cash on the sidelines, waiting for a big drop -- that would be market timing. But you might let some more modest sums accumulate over time, so that if the market crashes, presenting countless great companies now trading at more attractive levels, you'll be able to buy into some. Maintaining a watch list of promising stocks that you'd love to buy at the right price can prove very helpful when there's a market crash.
If you prepare yourself with a proper perspective on market crashes, understanding that they happen and are followed by recoveries, you won't need to worry so much about them -- especially if you're not making the mistakes above. Indeed, if long-term investors take advantage of the bargains they present, market crashes can actually be helpful!
