What should you do during the next stock market crash?
December 19, 2018
5 minutes to read
I started off with a preference for the title 'What should you do before the next stock market crash?' An article with that title may well be more useful and would certainly attract more readers. It would also be somewhat shorter. I would repeat the central message several times and back it up with some numbers. That would be "Above all, don't lose your head."
My advice would then be to stay put. The Niagara Falls on the stock market is never the same as the real thing. If you are approaching this part of the border between Canada and the US, I would immediately recommend the opposite – get out of the boat.
Anyone who sells their shares when some prophet of doom predicts the next crash is around the corner would never have bought shares in the last decade. The same people would therefore have completely missed out on returns of 140% between December 2008 and the present day. Not that things have been running that smoothly in the last four years in Brussels. For years, the Bel20 index has been going nowhere. 3,400 points today, or thereabouts? Almost four years ago it was also standing at 3,400 points. Yet 2018 was in the main a horrible year for Belgian investors. We went through a barren autumn, an icy winter, a lethargic spring and a sombre start to December. The Bel20 is now listed at roughly 10% below its peak of the last New Year.
Nonetheless, we cannot always talk about a crash. That's still years away – we may well soon be celebrating 'ten crash-free years'. Many of you – and logically, there are more and more of you – have never experienced a genuine crash.
As a survivor of several crashes, I will try to explain the task at hand to you in layman's terms: what is a stock market crash? What happens at such times and what is the best way to act?
Let us compare it to a building that catches fire. The number of victims in such a disaster depends on three factors: the flammability of the building, how many people are present in the building, and how many people can flee the building each minute. This last factor depends on the number of exits and their size. However, this is difficult to determine, as people will not flee a burning building in a calm and orderly manner. There will be panic. We therefore require a study on how the average person behaves in panic situations to determine this factor. But how do you do that? And what is an average person, exactly?
In short, nobody knows how the next disaster will pan out.
The parallel with the financial markets is clear. The number of participants on the stock market can be compared to the number of people in the building. The saleability at any time in the session (the liquidity: can I always sell a reasonably large tranche at a cheap price without the price plummeting?) is a pseudonym for the speed at which the building can be evacuated in an orderly manner. And the flammability of the building? Donald Trump brings in some flammable material, but the most flammable material is the extent to which major players are obliged to sell to plug holes elsewhere. And you know that the better the building burns, the less time there is to evacuate it.
Of course, people's lives are not at stake on the stock market, only returns. But as a rule, a burning stock market is more critical than a burning building. It is not because a building is on fire that the exits start to shrink at the same time. However, on a burning stock market the exit possibilities suddenly become limited. The liquidity dries up, and you no longer find any buyers who wish to pay an acceptable price for your shares. The burning material in a building will not suddenly become more flammable because it is on fire. Yet this is the case on the stock market: having problems selling leads to a wave of even larger problems when trying to sell. There are not more people in the building all of a sudden because it is burning. Yet this is the case on the stock market: a crash on a certain part of the market often leads to crashes on other markets. The flames creep up and continue, which results in the whole area being on fire. Or as in 2008, the whole world.
So yes, crashes are destructive. It's a shame, then, that they are entirely unpredictable. It's even more of a shame that we panic as if we are people in a burning building. Alan Greenspan, who had been Chairman of the US Federal Reserve for only a few months when the stock market crashed in 1987, was then the privileged witness of very scary scenes: "Several experienced high-level investors told me that they sold their shares at ridiculously low prices on that fatal day of 19 October, even though they understood that that was completely the wrong strategy. But it was stronger than themselves. The physical pain they felt when they saw their assets melting away was too heavy to bear. They preferred to seek salvation by running away."
"Try to put the crash into perspective" is some easy advice if you find yourself in the middle of the devastating chaos. But at the very least, you should always remember that the rise in the markets prior to the crash is always bigger than the crash itself. The statistics after and, above all, before the crashes of 2008, 2002 and 1987 suggest that a crash shows that it is nonetheless better to invest in shares than not.
Greenspan calculated the average annual return in the five years before the crashes as follows:
- 1929: 28%
- 1987: 24%
- 2000: 20%
- 2007: 12%
This represented an average of 21%. Or a return of 159% over five years. Or even: €100 invested five years before the crash is worth €259 just before the crash. The stock markets would have to crash 61% for the profit of €159 to be wiped out.
And 61% is no longer a normal crash. What's more, if you follow a reliable stock market system meaning you sell more or less on time, you should not experience such a large loss during a crash. Of course, we cannot say this should never be the case. If the world falls apart, everything does, right? Indeed. And if it gets to that point, the crash will be the least of your worries.
Furthermore, crises are opportunities, and most definitely on the stock market. Congratulations if you can keep your cool during the crash, because then you are one of the few. Most people see the stock market as Niagara Falls and get out. Any stock market crash will only be considered an opportunity in hindsight, while the next one will invariably be seen as a risk.
I must round things up, and it's time for some tips on what you should do.
Before the crash: make sure you diversify enough, take out your profits on time, sell losers and follow a proper system. Above all, always keep some cash in reserve so you buy after the crash. After all, after the rain comes sunshine.
During the crash: keep calm. It makes me think of the posters from the 1950s and 60s about what to do during an unexpected nuclear attack: then, too, it was the best idea not to leave the planet. And above all: don't lose your head!
Pierre Huylenbroeck is the author of Iedereen belegger [Everyone's an investor] and publisher of Mister Market Magazine, full of stock market insights and a real portfolio for subscribers to track, which in the last 22 years has achieved an average annual return of 12.3%.