What to Do When the Stock Market Crashes

A sudden collapse of stock prices always sets off alarm bells among investors. But is there anything you can do when your portfolio’s value starts falling through the floor? Here, moneyland.ch explains some common strategies for weathering a stock market crash.

Keep calm and drink tea

If you invest for the long haul and your portfolio is well diversified, you may not have to do anything at all. The historical return calculator on moneyland.ch show that investing in Swiss stocks has practically always paid off, in spite of stock market crises. Historically speaking, investors who used a buy-and-hold strategy could simply continue to hold their stock investments. The key requirement was that they continued to hold their stocks for at least ten years.

Of course, you can optimize your returns by taking measures when major crises hit. But the problem is that there is no way to know in advance whether current price developments are simply temporary dips, or the forerunners to a major crisis. There is no guarantee that taking action gives you any advantage over simply being patient and waiting it out. Additionally, making changes to your portfolio normally generates added expenses.

It is important to note that historical developments are not a completely sure basis on which to predict future developments. That means you can never be absolutely certain. There is always a chance that the next crash will be the first in 100 years from which the Swiss stock market never recovers. But that is a very unlikely scenario.

Buy precious metals

During market crises, investors tend to take refuge in so-called safe havens. Some precious metals, like gold, fall into this group. They are considered to be crisis-resistant, but in practice, their prices usually do tend to drop along with a market collapse. The probable reason for this is that when the stock market crashes, many investors are left in desperate need of money – to cover margin calls, for example. Because the gold market is very liquid, a need for quick money often causes a rise in gold sales.

But the price of precious metals usually recovers much faster than the rest of the market, as investors begin to systematically transfer their wealth to these safe havens. Over the longer term, the price of gold often makes significant gains even while the stock market is still in crisis. For that reason, some investors see stock market crashes as an opportunity to buy gold cheaply.

Go on the defensive

So-called defensive or countercyclical stocks are also considered to be a safe haven for wealth. They get their name because their prices do not follow the overall economy. The stocks of consumer goods manufacturers and healthcare companies are examples of anticyclical stocks. Demand for the goods and services of these companies remains relatively constant, even if consumers spend less money in other sectors.

Defensive stocks also tend to lose value when a crash hits, but normally at a lower rate than cyclical stocks. They also tend to recover faster.

Defensive stocks are less likely to collapse, but they are also less likely to experience strong growth fueled by speculation. For investors who take refuge in defensive stocks, stability is more important than growth.

Park the money in your bank account

The logic of investors who sell their stocks and park the money in bank accounts when the market shows signs of a crash is: Only people who are invested in the stock market have to worry about it crashing. By holding a bank account balance, you preserve at least the nominal value of your money, and have very little risk. If a crash triggers a period of deflation, you may even make a real return.

But aside from that scenario, chances of earning returns are small. Currently, Swiss banks only pay little interest.

One of the risks of this strategy is getting the timing wrong. If you respond to late, and the biggest losses are already behind you, withdrawing to cash will not help you much. If, on the other hand, you withdraw from the stock market early on, and the dip turns out to be a simple price correction rather than a crash, you also will have gained nothing by parking your wealth in banks accounts. You also risk reentering the market at the wrong time, and missing major growth spurts.

Every new purchase or sale of securities costs money. Selling your entire portfolio and then building it up again from scratch can end up being much more expensive than simply holding your investments (the buy-and-hold strategy). In the best case, you will get your market timing just right and earn enough additional returns to make the extra costs worthwhile. 

Get rid of risky investments

For most investors, risk capacity sinks during times of crisis. That is why speculative investments often go on sale when signs point to a crash or recession. For example, if there are fears that a small growth company will not be able to survive through the economic drought, many investors may avoid its stock.

The disadvantage of this strategy: Normally, higher-risk investments also have higher return-earning potential. Those who ditch riskier investments in favor of defensive assets or part their money in an account must be ready to accept much lower returns – or none at all. For most investors, who generally do not expect to make returns during period of crisis, this is hardly an issue.

Go bargain hunting

For so-called countercyclical investors, a stock market crash is the Black Friday of investing. Prices nosedive, giving them a chance to buy up the assets they want at a discount. Investors who do this hope that the downward trend will soon reverse so that the value of the assets they bought cheaply will quickly gain in value. If all goes as hoped, anticyclical investors can recover their investment and make sizeable returns within relatively short periods of time. But this kind of investing is considered to be very risky. Its success depends largely on whether or not prices begin to go up again after you buy. Buying a stock at a big discount on its peak price will do you little good if the price drops by another 50 percent afterwards. In that case you may have to wait a long time until the price recovers enough for you to be able to sell at a profit.

But even if you do not get the timing perfect, buying when prices are low can still pay off over the long term – assuming the stock market eventually returns to its former level, as has been the case historically.

Diversify your timing

Some investors make use of unit cost averaging when markets indicators begin to point towards a crash. Instead of investing in a single lump sum, they buy the desired asset over time in a series of smaller purchases at regular intervals as prices drop. Because they invest exactly the same amount in exactly the same asset at every interval, they buy more of the asset when the price is lower. This results in a lower average price per unit.

The point of this strategy: Unit cost averaging lets you profit from short-term fluctuations without the risk of investing all your capital at the wrong time. If the drop in prices turns out to be a crash rather than just a price correction, unit cost averaging lets you buy assets at various steps along their downward journey, which lowers losses compared to going all in at a time when prices still have a long way to fall.

The disadvantage of investing in tranches is that your returns will be lower than they would be if you could time the market and invest all your capital once prices have hit rock bottom and begin their turn-around.

Bet on falling prices

Short selling and put options let you profit when the value of assets declines. Some investors make increased use of these vehicles during periods of strong negative market developments.

The biggest disadvantage of short selling compared to long positions is that it is possible to lose more money than the total amount you invest. On the one hand, there is the potential return. On the other hand, there is virtually unlimited potential for loss. The price of the asset may – contrary to your expectations – go up, and at least theoretically, there is no limit on how high the price can climb. If it does, settling the resulting debt could require that you paying a lot of money on top of the initial amount you invested. Another possible risk of short selling is that you may not be able to freely decide when to exit a position. Because of these and other risks, short-selling generally is not suitable for inexperienced investors.

Another point to consider is that short-selling is a controversial practice. Some argue that it encourages investors to try and profit from the economic suffering of others. Additionally, large-scale short selling can contribute to worsening existing crises.

Hedging

Hedging is a conservative strategy for investors who expect an abrupt drop in market prices. These make use of derivatives (such as futures and options) to secure against the risk of price changes. When the value of an asset in your portfolio goes down, the value of a corresponding derivative goes up. In this way, your wealth is preserved in spite of a market crash.

Unlike short-selling, hedging is not betting on falling prices. You do not sell existing positions and replace them with new ones. Instead, you add new positions which balance your existing assets.

This strategy has its disadvantages as well: With this type of hedging, when the value of assets climbs, you either do not make returns, or make lower returns than you would otherwise. Typically, you make neither a gain nor a loss, but simply preserve your existing wealth. Because of that, correct timing plays an important role in hedging. Another disadvantage is that using derivatives costs money. Hedging is also only a viable option for investors who have enough capital on hand to make the necessary additional investments. 

Buy bitcoin

Not all investors shy away from risky investments when markets shake. Some believe that bitcoin compliments gold. The hope is that the cryptocurrency will maintain its price through periods of heavy inflation, and thus keep up with currency devaluation.

Additionally, the cryptocurrency market is not directly related to or depending on the stock market. That means it is possible for bitcoin and other cryptocurrencies to retain their value or even gain when the stock market crashes. However, that possibility has, until now, not yet materialized, with cryptocurrencies having fallen even harder than stocks during previous stock market crashes.

Stop losses

Some investors try to protect themselves from sudden losses by using stop-loss thresholds. The idea: If the price of an asset falls below a certain threshold, the asset is sold immediately. In the event that the price of the asset continues to nosedive after that, investors who had stop-loss thresholds in place will not be affected.

This strategy only makes sense as a precautionary measure. Once the market is already in freefall, it may be too late to add a stop-loss threshold in time to prevent losses. If you sell once prices have already begun to collapse, you will likely sell at a loss. You should also understand that adding a stop-loss instruction or order to a position does not guarantee that the asset will be sold at the stop-loss price. When the price reaches the stop-loss threshold, a market order is triggered, and the broker sells your assets to the highest bidder. When prices are falling fast, the actual price you get may be well below the stop-loss threshold.

The danger of these limits is that your assets may end up being sold during a short-term price correction. If the price recovers right after, then selling the assets will have been a mistake. That is why it is important to choose a stop-loss threshold which is below the range of temporary price corrections.

Avoid leveraged trading

When prices nosedive, the stock market can become a death trap for those who invest on credit. During bull markets, many traders invest on margin – meaning they use loans secured by the value of their existing assets. Because the collateral itself is often dependent on the stock market (if you hold stocks, for example), its value can fluctuate and, in the case of a crash, even collapse. When that happens, you risk a margin call, and the resulting need to either bring new collateral or sell your assets at a loss to cover your debt.

In order to minimize losses, it can make sense to close margin-based positions before prices begin to fall significantly. The disadvantage is that by reducing your overall exposure to the market, you lower your potential for earning returns as well as for making losses.

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