How to Profit From A Stock Market Crash
The stock market has had some rough days lately, with the Dow Jones Industrial Average experiencing 17 daily declines of 100 points or more (including two 1,000-point bummers) in the first quarter alone.
In markets like these, you'll read a lot of advice about hanging in there and riding it out. The truth is, if you are a long-term investor, you shouldn't just ride out these stock market storms -- you should learn to love them.
After all, while a stock market crash can rattle even experienced investors, it also represents opportunity. You can either be victimized by a stock market crash or profit from it. The difference is in how you prepare.
Buy more stocks at lower prices
Buying low and selling high is never as simple as it sounds, because it isn't always clear what "low" and "high" are. However, if you are committed to putting money into the market steadily over time, bear markets will help you buy more stocks at lower prices.
If you keep making regular investments as the market declines, you will be buying at progressively lower prices and, consequently, lowering the overall average price you paid for your investments. This is called dollar-cost averaging and, when you lower your average cost, you increase your long-term return.
Creating opportunity - a dollar-cost averaging example using actual market history
From the end of October 2007 through the end of February 2009, the S&P 500 (a broader measure of the U.S. stock market than the Dow) lost just over half its value -- a traumatic event for investors. Over the subsequent nine years or so, the market recovered nicely and, overall, is now 70 percent higher than before all the trouble began.
While it might seem like it would have been nicer to just earn the 70 percent without the trauma of the stock market crash in the meantime, that decline actually created an opportunity for long-term investors to earn a higher return.
Consider an investor with $500,000 heading into that bear market and investing an additional $1,000 per month in the S&P 500. Through all the ups and downs, that investor would now have $1,074,259.
The funny thing is, had the market not crashed before recovering, but instead had earned that 70 percent in nice, steady monthly increments, that investor's portfolio would be worth $57,242 less -- at $1,017,017. The ups and downs of the market created opportunities to invest some of the money at lower prices, which raised the overall return.
Why millennials (especially) should love a stock market crash
Stock market setbacks can be especially upsetting to newer investors going through it all for the first time. However, newbies especially should welcome the idea of a stock market crash.
Think of it this way: The stock market has been going up for nine years now. If you are just starting to invest, would you rather get into the game at today's elevated prices or do you wish you'd had some money to invest a few years back when the market was a lot cheaper?
A bear market now could give you the opportunity to buy stocks at lower prices -- and the benefit for new investors is even greater than for people already heavily in the market, because the newbies have less to lose going into the decline.
New investors - how much profit is there?
The example given previously showed that someone starting out with $500,000 and investing $1,000 a month would have 5.6 percent more money today because of market fluctuations than if the market had earned the same long-term return at an even pace. The benefit would be even greater to a new investor.
If you had no investments when the last bear market began but started putting $1,000 per month into the market at that point, you would have $222,025 today. This is nearly 35 percent more than you'd have if you'd put $1,000 per month into a market that earned the same long-term return in equal monthly increments. The stock market's decline would have given you a chance to ramp up your investment at lower prices, increasing your long-term reward.
How to prepare for a stock market crash
Here are things you can do to prepare for a market decline:
- Consider your time horizon
It took about four years for the S&P 500 to recover from the last bear market, and that is not unusual. Think about your upcoming needs -- and if you plan on tapping into your investment account in the next few years, you may want to pull some money out of stocks now.
- Decide on your long-term plan
Courage often fails investors when a market is tanking, so decide in advance whether you can commit to keep putting money into the market if prices go down.
- Have a shopping list of portfolio upgrades
It seems the great companies are almost always trading at high prices, but a bear market can be an opportunity to buy world-class stocks at a discount. Have your wish list ready so, if a crash comes, you can act decisively to load up on top-quality companies.
None of this is to say you'll love a market crash while it is occurring. However, if you play your cards right, you may be able to profit from it in the long run.
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