How to prepare for a market meltdown
The mere thought of a stock market crash gets many investors riled up.
Maybe it shouldn’t, but don’t blame yourself or others. That’s simply our lizard or caveman brains hard at work. The reality is, we’re naturally wired to be bad investors.
This is because the same area of our brain (the amygdala) that responds to fight or flight for the last 100,000 years sees financial losses as the same way as a big, mean, nasty grizzly bear running after us. So, whether this big bear (a big financial bear at that) is real or just perceived as being real, our brains do not discriminate. Our hearts will race, our palms will get sweaty and we’re apt to click the keyboard and sell a stock or a bond or anything in between based on our fight or flight response.
Watching what goes up go down, way down
Watching your investment portfolio crash can and would likely be, devastating. So, with our amygdala fully engaged, we’ll have higher levels of cortisol running through our bodies to fight the stress.
Our risk appetite will sink and during higher periods of market calamity, that means we’ll probably act in the opposite ways we should:
We’ll sell low instead of buying low or holding the line.
Needless to say, I think market volatility and watching your portfolio go down can have detrimental affects on the portfolio you’ve worked so hard to build. If you’re an investor who might panic and react, when your investments drop in value, you might incur major long-term consequences.
Thanks to a reader question of late (adapted slightly below), I thought I’d highlight some things to consider (and what I think about and do) to prepare for a market meltdown.
With all the news of late, I’m really not sure how to prepare my portfolio for a market correction exactly.
Most of my stocks (I don’t have bonds or GICs or fixed-income-oriented ETFs) have unrealized gains.
My TFSA is full of Canadian bank stocks and Enbridge. My RRSP has some utilities.
Within my non-registered account, I have a mix of banks, insurance, utilities, CNR (Canadian National Railway), and telecom stocks, ALL with gains. I know if I sell anything in my non-registered account, I will pay tax on my capital gains. If I buy back some of the same stocks when the market dips during or after a correction, I will have a revised adjusted cost base (that I need to calculate).
I do have a cash wedge to use, to buy some stocks when the market corrects, but otherwise everything is tied up. So, what can I do to help prepare for any correction? What are you doing?
Great questions! Boy, lots to unpack there.
In no particular order, here are some key things I would consider (and what I’m doing) to prepare yourself for any market meltdown.
Review your risk tolerance
Will you make a portfolio change, including selling stocks and buying more bonds, when the equity market drops 10%? 20%? 30%?
I think knowing this answer or these answers is key.
The best time to put any plan in place is before you need it. Financially or otherwise…
That means when it comes to investing, think about your risk tolerance today and identify what you might do in those situations above. If you think you’ll sell assets when the market is down 10% or maybe 20% (or more!), you probably have too many equities as a % in your portfolio. And that’s OK! It simply means you need a more balanced stock-to-bond mix and/or you might need a more global, well-diversified portfolio that you could ride out.
Consider some of these low-cost, highly diversified ETFs to build your portfolio with.
What I am doing?
I’ve reviewed my financial plan a few times over in recent years and I’m rather confident I will not sell any of my Canadian dividend paying stocks or my U.S. ETFs (disclosure: I own U.S. dividend ETF VYM) when they are down 20% or even down 30% in price.
I have a plan to live off dividends – to some degree.
Doing so helps me stick to an investing approach I thoroughly believe in. Besides that belief, I would be absolutely shocked if some of these companies stopped paying all their dividends, in a prolonged market downturn, all at the same time.
Image courtesy of iShares. FYI: A boring buy and hold strategy with XIU would have earned you ~ 7% over the last decade. Basically, your money doubled in those last ten years.
Embrace (and learn from) market history
Rather than trying to time the market, beat the market, outsmart the market – the list goes on – I think it’s very helpful to remember that crashes have happened and consequently, they will happen again.
This was a great tweet I found recently – something to remind yourself about when it comes to market history:
Long-term, stocks should go up in price. They always have.
This means having a long-term, multi-year, well thought out investment strategy (including knowledge of market history and how it usually repeats) will help you with your investing reasoning and decision-making.
What I am doing?
Since starting My Own Advisor, I’ve absorbed a good dose of market history. I use it as one tool in my investing toolbox to avoid making snap financial decisions.
Keep some cash – aligned to your investing approach and timeline needs
Based on my readings and experiences with #1 and #2 above, I’ve learned market corrections tend to have the biggest impact on those that need the money in the near future (more than others).
That only makes sense.
You certainly don’t want the equity portion of your portfolio to vapourize when you’re expecting to use that money sooner than later…
This means as investors move closer to retirement time, or at least when they need money for expenses, they should consider owning some more fixed-income assets and/or more cash inside their portfolio. You can do this by selling some of your profitable assets today, when the market is frothy OR keeping more cash across your portfolio, starting now.
In some cases, as the reader pointed out, selling assets might incur a capital gain. Unfortunately this is part of the trade-off that comes with successful taxable investing. Look at it the other way. A capital gain means your investments made money. That’s a good thing…
I wrote about taxable investing including tax efficient taxable investing here.
At the end of the day, only you can decide how much fear or anxiety the stock market might be causing you. If you’re worried about the future, if you have some profits on your table that could be opportunity to make some portfolio changes before you really have to.
Further still, keeping some cash on the sidelines now, for an unknown future, is generally smart planning. If you don’t sell any assets now, consider squirreling away a few extra dollars into a savings account via automatic contributions as another way to hedge the market bears. At least this way, you don’t have capital gains to incur and you have more cash on hand when $hit hits the fan!
What I am doing?
Over many years of running this blog, although I didn’t always have one, I’ve embraced the merits that come with owning a modest emergency fund. We try to never touch these funds unless we absolutely have to. It’s cash, sitting in a savings account, collecting interest – liquidity if and when we need it.
Sure, there are opportunity costs with keeping cash but it’s nice to know I don’t have to go into debt to use money in an emergency.
Longer term, as we march towards to semi-retirement, I’m thinking we’ll keep much more cash on had as part of our modified cash wedge. I’m anticipating keeping one year worth of expenses in cash.
This is our upcoming cash wedge approach here – once we open the investment taps.
Thoughts on that? Retirees who do the same and keep a cash wedge on hand?
No one has a crystal ball when it comes to the stock market. Those that think they do, including any financial experts, are only kidding themselves. Hopefully you’re not fooled by any of them.
Our lizard brains often remind us that feeling any loss, including a financial one, typically brings twice as much pain as any joy we might get from an equivalent gain.
While our caveman instincts have helped us tremendously over the years; to gather food, fight bears in the wild, these same attributes work against when it comes to money management. Now you know!
Hopefully by following a combination of these three tips you can be better prepared for any market meltdown with me.
I want to hear from you. How do you prepare for any market meltdown? How did you survive the last great recession 10+ years ago? What did you do and what insights might you offer others including a younger generation of investors?
i have 40% of my portfolio in VAB , even though the returns are not as high as stocks but i get a good sleep at night knowing that a good portion of my portfolio is somewhat safer , and to be honest lately Vab has been steadily in the green.
VAB is a great low-cost fund. Smart stuff.
I left a rather long list of the various types of risk in a previous comment. I guess the point I was trying to make is that when the word “risk” is used in an article the type of risk is never specified. For instance, equity price volatility is of little concern to me, yet I think that that is what most people view as “risk”.
Fair enough. I was referring to generally market risk – and you’re right – I did not specify but could have. I see unfavourable changes (that folks don’t plan for nor anticipate will happen) as having a huge impact on their portfolio risk – i.e., they do something stupid 🙂
Folks can help themselves when it comes to market risk, company risk – via diversification; learning from history and keeping cash on hand.
Folks have no influence on inflation; interest rates; broad-sweeping taxation changes (although they can vote!); inside company influence (although they also have a vote as a shareholder in some cases); currency risks (although they can choose to keep assets in one or more currencies); nor geo-political risks. As such, soooo many things are out of our hands.
Again, good dialogue on this.
I am 11 years retired. This comment is in response to your “cash wedge” and emergency fund. My income delivery is all from dividends. I have not withdrawn any capital yet. In fact I have built more which increases income.
I have found it helpful to keep my “investment finances” and “household finances” totally separate.
Like you I keep one year’s expenses in my day to day “household accounts”. (This has been drifting upwards lately). Not too concerned about that. I keep $0 to $15,000 cash in my “investment accounts”.
Also I have a serious problem with what to do with my unrealized capital gains tax-wise. I have not yet found a solution. They just keep piling up.
You have a great problem to have John. Have you considering selling off some assets, slowly, while letting the dividends for some assets continue to accumulate? Maybe you’re waiting for a small correction to decrease your adjusted cost base? You could also consider donating your shares at some point.
Donation of securities in-kind, will avoid the taxable capital gain AND you receive a charitable receipt for the market value of the securities on the day you initiate the transfer. Just a thought, not a recommendation but something to consider to help others and your wallet at the same time.
I think eventually I will have the ~ 1 year of expenses as you say; as “household expenses” saved up and then just let the dividend income and distribution income from ETFs do it’s long-term thing and pay me.
Risk tolerance is mentioned in many articles. I have analyzed this to the best of my ability. This is what I have come up with.
Risk tolerance: Types of risk: (listed in order of very important to not so important.)
Inflation risk: very low tolerance
Interest rate change risk: very low tolerance
Liquidity risk: assets should be very liquid (Widely held)
Company risk: low tolerance (large companies diversified across sectors)
Market risk: very high tolerance. Not concerned with price volatility. Market trends and developments must still be monitored for unfavourable changes. e.g. the buggy whip, steam engine, Kodak, etc.
Currency risk: very high tolerance. The account will convert foreign currencies to Canadian dollars at the time of transaction. The reason is that I live in Canadian dollars.
Domestic political risk: inevitable. e.g. income trust tax changes or changes to capital gains inclusion rates.
Geo-political risk: Avoid direct exposure. Global equity exposure can be obtained through US multinationals. ADRs are in general not acceptable due to currency conversion spreads and fees.
An individual company comes with its own risks. For example. Fire, earth quake, lawsuits etc. While this concerns me as an owner, it is management’s job to manage those risks.
Personal emotions risk: (fear, greed, ownership bias, agency problem, recency bias). This risk belongs at the top of the list, but psychology is a difficult mushy subject so I put it at the end of the list. Be self-aware of motives every time work is done on a portfolio. (Do not underestimate the difficulty involved in doing this.) This risk is impossible to eliminate. (cave man, amygdala brain)
That’s a strong list John. Thanks for sharing that. Although I agree with your geo-political risk; e.g., I don’t own any ADRs yet but I have considered them for my portfolio for sure.
The personal emotions is a very tough nut to crack!!
Great post Mark, thank you.
My strategy has been to keep buying monthly, ignore the markets and stick with a 60/40 equity/fixed income etf portfolio. Going on 30 years of investing and about 5 more years to go. Will use something similar to your 3 bucket approach with a 2 year cash wedge when I plan to retire. I need the funds to last a long time during retirement and sticking to this plan should work out over the long time horizon.
Most welcome Charlie. I know I’m not alone when folks ponder this stuff…
A two year cash wedge is great for risk mitigation and I think if you can live off a 60/40 equity/bond portfolio AND have that cash wedge, your portfolio is probably as solid as it can be for growth and income and stability.
A timely and helpful article. Thinking about this to prepare for a potential/likely? downturn is a good idea for an investor.
As a retiree I have an investment policy statement that covers our overall approach and what my investment disinterested wife should do if I’m gone, and also have a written plan for actions based on a downturn. Far from perfect but will probably help ground and steer us if needed. Where the rubber hits is the road is being able to follow the plan whenever a real downturn happens. I’ve always stayed invested since my first big experience with a market dump in ’87 about 4-5 years after I started investing.
Since leaving work having a sizable FI component (cash, bonds, gics – 10+yrs worth of spending at current levels) is some peace of mind as a backstop and could provide opportunity to rebalance at some point when stocks are cheaper. In Jan I bought about 50K of stocks after the quick dip in Dec. Stocks and ETFs that pay dividends also should help provide some measure of income stability during bad times, but we’re relatively ok if that is interupted for a number of years. YMMV
For those in the accumulation period a downturn should be a welcome opportunity rather than a real scary time, if they can keep focused on the long term picture within a plan. Easier said than done but possible especially if one is invested properly and prepared.
@RBull, in Jan bought 50K of stocks. That’s great move. I hope I have done that too.
I think the problem is people always overestimate their tolerance to risk.
During 2008/2009, I didn’t do much as I was very busy with babies and didn’t pay any attention to the market.
And since I began to actively invest again, my plan was always buy when market is down. Unfortunately, when it really happened, I could not conquer my fear. I should have bought in December/January too, but I didn’t.
Hopefully at least I will not cut meat on the floor.
Thanks May. Some of that has panned out far so and some not. In the long term it’s all fine.
Probably true about overestimating risk tolerance. If you have your asset allocation roughly in balance don’t think you should fear buying. You’re in accumulation mode. I’m not and have been raising my equity exposure a little bit per my plan. We’re good here until we see a decent retreat. I haven’t been able to raise any more cash for a while because I had some significant home costs and a couple of nice trips to pay for, but hope to in the next 6 mths. I have a number of stocks I want to buy and at least one ETF – at some point. I’m sure I’ll be posting here about buying again but sure can’t predict it will ever be the best timing.
You and your husband are in great shape and headed soon for very great shape. Best wishes.
Yeah, I know I should not fear buying. But emotionally, I kind of do. Since I actively invested a big lump sum at end of year 17 when market was already quite high and I was pretty much not experienced in this game at all, I have quite some stocks still underwater. CM, BNS, ENB, CVS, to name a few. I don’t really worry about those, but still not a very good feeling to see those red numbers. I guess I was tempted to time the market a bit which is not good.
Need to collect my courage to follow my plan and stick to my AA no matter what. Right now I have more than 40% FI, which is not my plan. Really need to correct that.
I understand. I have some red showing too due to selling and taking gains from etfs, buying stocks. Some good some not. A fact of life for stock pickers. In the long term big picture this will be fine, and will generate income for me in the meantime. Your drips can do the same thing when stocks are lower. Concentrating on dividend growers helps too as you know.
I have gone from 50% to 65% equities over 5 yrs and am fine here for now. This is intentional and fortunately mostly is due to market gains. Eventually I may be 70-75% equity but hard to say.
It’s near impossible for someone who has done most of their investing in the past several years to avoid buying higher. I would agree to stick to your AA if that is truly well thought out and your plan. You might do much better waiting to invest but who knows when and by how much. Because you’re still working and generating good savings cash you can continue to buy whenever the market really dips and you can also use FI to rebalance.
Yes, my plan is 40% FI and right now I have almost 50%. I might gradually reduce FI after I feel more comfortable. I need to get to 40% first.
With both of us working and we basically live on one salary, I have new money every month to invest and I didn’t even do enough of that this year and that’s why the FI percentage is out.
I feel I am having this one more year syndrome. Basically, for both of us working one more year means even the cash savings will be enough for the family living for another year. I guess I have to decide how much is enough and enough is enough. Anyway, it’s only two years after I made my five years plan. Three years to go and hopefully by that time, recession has already come and gone.
Probably very true May. What I think I can stomach may not turn out to be true – you never know! This is where I believe a dose of market history can do wonders for investors. Over a decade or more of investing, the chart tells the tale and history tells us: stock returns > bonds, bonds > idle cash.
Mark, IMHO I would generally agree but think one needs more than a decade to get a more accurate picture, and there will likely always be exceptions. We’ve seen it in Canada and the US. What will the next 10 years bring?
Here in Canada for the past decade bonds have outpaced stocks. 2008 to end of 2018, without drama!
Initial balance 10k; final balance; CAGR, max drawdown
XBB 15,445 4.03% -4.18%
XIC 14,110 3.18% -43.58
XIU 14,406 3.37% -43.08
Realized I did 11 years above. What a difference a year makes with the big recovery- 2009-2018 (10 yrs) below.
XBB 14,540 3.81% -4.18%
XIC 21,166 7.79% -17.10
XIU 20,905 7.65% -17.08
Now 1999-2018 -20yrs
XBB 21700 4.66% -4.18%
XIC 28145 6.28% -43.58
XIU 29266 6.52% -43.08
Thanks, RBull, It’s a big eye opener anyway. I always feel Canadian equity market index is not so good, your number proved that.
I think I will buy some XBB for my AA. Too much cash on hand right now.
You’re right, bonds may outpace stocks in certain decades or periods. That may be true depending upon the time frame chosen. I will however take my chances that stocks > bonds > cash in the coming decades for me.
My preferred bond etf is zsp. It’s the big guy, most liquid and has a slight tilt to more corporate.
To be clear May its much less likely bonds will do nearly as well as they have in the past few decades. I haven’t verified but I think ZSP returned overall about 8% in the past year.
ZSP = S&P 500? ZCS?
ZSP (in CDN $) has returned some impressive numbers of late:
1 Year 2 Year 3 Year 5 Year 10 Year Since Inception
NAV 9.09% 14.78% 13.27% 15.17% – 19.02%
Index 8.91% 14.81% 13.62% 15.59% – 19.50%
Fair enough. Although I expect all of us that invest in equities whether 100% or with some portion of bonds are taking that chance stocks will outperform bonds over the long term. I certainly am. If I didn’t think that I couldn’t see any reason to own them.
Indeed my friend. I understand your rationale.
Thanks, RBull. I will buy bonds to protect the principal, definitely not for growth. For long haul, stocks will most likely outperform bonds. But I am not comfortable enough to hold too much equities yet.
As Mark pointed out, in long haul, bonds should perform better than cash. It’s already an improvement for me to hold bonds instead of cash. I am taking baby steps for investment.
May, you’re well on your way….if you understand your personal portfolio risk profile and can adjust on your own. Baby steps become hands off eventually = don’t worry. 🙂
Based on what you’ve said that sounds like a great plan May. I buy bonds for the same reason. Most of what I have is individual corp bonds but also have the ETF for liquidity.
Lol, ya ZSP = great but unfortunately that’s not what I meant.
Thanks for catching that Mark. We were talking bonds ZAG is what I meant to write. Oh my, talk about a brain fart.
Sorry for that May or anyone else.
Thanks Mark. I understand your rationale too. I did the same thing when I was in accumulation mode. When I got close to retiring I lost my mind (or my nerve, or both) and became more conservative! Something in there about winning the race too…..I dunno. But somehow it seems to be working well enough for us so far.
@May “I think the problem is people always overestimate their tolerance to risk”
I got an email from a family member asking about a Tech ETF. I was going to answer his question indirectly by talking about what is risk. It’s only when we log in to our accounts and see that the value has dropped by 25% that we truly appreciate what the term “risk tolerance” really means! It’s only when you come out on the other side of a few dividend cuts and bad stock picks that you truly develop an understanding of what risk really is! But it’s going through this that makes you a better investor. I’ve gotten really good at understanding the difference between “in trouble” and “on sale” I’ve average 10% over 20 years. Some due to luck (buying 30 bond when interest rates where north of 5%) but also due to really understanding what risk is. I’m still 100% stocks and always will be.
Thanks a lot, Rob. All you said is so true. I was very bold two years ago. Now going through one dividend cut and some of my stocks dropped more than half, I am very cautious now, maybe too cautious. I need to become more braver to reduce my FI to 40% first. Hopefully I will be comfortable enough to hold 100% not in very far future. Beginning to buy a little bit here and there recently.
Yupp been there done that and burnt the T-shirt. My thought in all of this is to go back and look at why you bought each stock in the first place. What was rational behind the decision. Did it work out as planned, do you need to adjust how you invest etc. As a dividend investor the big lesson for me was not chasing yield but instead buying dividend stocks when they are on sale.
BTW what are you referring to when you say FI to 40%?
My planned asset allocation for now is equity 60% Fixed Income 40%. Right now I have almost 50% Fixed Income, too much I think.
As you know, I’m hoping for a downturn but that doesn’t mean I’ll get my wish!
“For those in the accumulation period a downturn should be a welcome opportunity rather than a real scary time, if they can keep focused on the long term picture within a plan.”
Well said and trying to learn from others in that regard!
Thanks. I’m 100% certain you’ll get your wish. When? I’m not certain on that part.
It’s quite interesting you’d mention this as my wife signed up for an employee stock purchase plan at her job. With the recent drop in stock prices the CEO had to send out a letter saying the company was doing fine and not to panic. I told my wife that, for us, this is really good news. I did some research and analysis figure the stock is a good 40% undervalued. The lower price has meant she’s getting an extra share per month!! Plus all that matching!
Now the downside is that this money is ear-marked for a truck and 5th wheel when she retires (T minus 3 years 5 months) and I’m hoping the stock price will be back by then. I’m a bit worried that it won’t be and I’m loath to sell if it’s still undervalued. Not quite sure what we’ll do if it hasn’t.
The downside to this is those who are about to retire. I just emailed my brother in law one your recent columns with a note not to check his statements!
Lower prices, great for buyers. Higher prices, not ideal but still good when you have money to invest 🙂 That’s all I do is follow that rule.
If it wasn’t for all the condo buying and stuff, (i.e., we wanted to rent and not own any real estate), the portfolio would be over $1 M now and we would have hit two major financial goals: 1) our portfolio goal for semi-retirement and 2) no debt goal as well.
Ah well – condo ownership was important to us and so the journey continues…!
This is a good article on a great subject. I can spend hours in my delusional mind going over (and over, and over) the “what ifs” and I almost never come to a solid consensus or a plan.
I think many investors can suffer from analysis by paralysis. Once you realize you don’t know what you don’t know, and you simply make a good risk-adjusted plan that suits your long-term goals, you really have little to worry about.
Ya, I moved $400K out of equities in the fall of ’17 within the RRSPs and did some GIC laddering. Between those funds, our pensions, CPP/OAS we’d be fine no matter what happened market wise. The TFSAs are 100% equities and there is still a very large equity position in the RRSPs yet. On top of all that I’ve got some non-reg GICs sort of laddered on a two week renewal for an emergency fund. It’s not really a “plan” but it will do for now. If political stability returns to the world or we get a decent recession/market pull back I can see doing some more investing but I don’t know what for. The memorial endowment funds are going to get a substantial boost when we kick off unless something drastic happens.
I think if you’re waiting for political stability – you might be waiting a very long time. The new normal is chaos sadly.
Just noticed this.
Well said on both the analysis by paralysis and on political stability.
I’m very inclined to agree.
I mean, why worry about what you can’t fix, influence or don’t know? Useless energy. Use energy to be productive, give back, understand where there is a time value for money and ROI. Just me. I have a small brain though! This site is MUCH smaller than many U.S. bloggers. I guess I don’t have many books or other assets to sell.
Oh well. It’s fun. 🙂
Ha, you certainly don’t have a small brain. You’re offering a lot more here than most. I guess you don’t have to be the biggest to be the best.
Yes, useless energy. Focus on what you can control.
Lloyd your endowment plan is an amazing touch. It shows you and your wife are very good people that will help many.
Kudos. What you explained above is precisely a plan. And a very good one at that.