Follow these two simple investing rules for stress-free investing when everyone else is freaking out about a stock market crash
Stocks of the largest U.S. companies plunged 10% in one week late last year and closed flat for 2015. The selloff hit investors in the high-flying market for Chinese stocks with a whopping 25% drop from the April high and pundits were quick to make comparisons with the stock market crash of 2008.
The way stocks are going so far this year, it doesn’t look like it will be a great year for investors. Any time the market wobbles for two years in a row, it’s always a warning sign of trouble and the potential for a stock market crash.
That could be bad news for investors, especially the ones that have just recovered from the collapse of the housing bubble. It seems stock market crashes have been getting worse lately with the last two topping the list of the top 10 stock market crashes in recent history.
I answered a lot of emails over a period of two months from frantic investors worried about their nest egg. My stocks didn't shoot higher, in fact many of them went down as much or more than the general stock market. So how did I stay so calm?
Why don’t I care about the next stock market crash?
I used to worry about the daily ups and downs of my stocks. As an investment analyst for other websites and private clients, I watch the market daily and hear every fearful quip about a new correction or full-on stock market crash.
Have I achieved some inner peace, a level of Zen that has helped me transcend earthly worries?
Nope…but I do follow two simple investing rules. Two rules that every investor should follow to make investing nearly stress-free.
What is the Risk of a Stock Market Crash Now?
I want to make this post more general and don’t want to talk too much about the risk of a stock market crash right now but let’s go into some of the forecasts.
It is more than seven years since the economic recovery began and stocks started rising. While a business cycle and bull market don’t die of old age, there is reason to believe we could be in for a recession within a couple of years.
The Wall Street Journal surveys economists each month for the risk of a recession and recently put the odds at 21% of a crash in the next year.
That’s not too high but still much higher than it has been over the last few years.
Don’t let the one-in-five expected chance of a recession make you think there can’t be a stock market crash though. Economists aren’t great at predicting these changes but are pretty good at telling when the chance is more likely.
Even if the risk of a stock market crash isn’t very high, the stock market has been booming for seven years. That’s a longer run than nearly every other bull market except the tech bubble of the 90s. At the price investors are paying for stocks now, there might not be a lot of upside left in prices.
What we’ll see in the next few sections though is that it might not matter much for a long-term investor.
How Much Risk can you Afford in a Stock Market Crash?
The first rule of investing, one that gets very little attention from pundits and analysts on TV, is the need to know your own risk tolerance. This is how much of those stock market ups and downs you are able and willing to take, something we talked about and calculated in an article last week about investing risk tolerance.
Investing is about taking risk. It’s not gambling but a calculated risk that you’re willing to take for a return on your money. Notice the words you’re and your in that last sentence? It’s your money at risk so why do people spend so much time listening to some TV ‘entertainer’ scream out what stocks they should be buying?
One of the worst things you can do is listen to stock market pundits in the financial press tell you when and what to put in your portfolio.
Your risk tolerance will determine in which investments you take a position and how much of your total portfolio you invest in each.
Older investors with fewer years to retirement and lower ability to take risk will want to hold more bonds and real estate investments. Don’t think that time to retirement is the only factor in your risk tolerance. Some people may just prefer less variation in their wealth, they have a low willingness to tolerate risk. If you’re someone that would rather watch your wealth build slowly and would lose sleep over losses then you will want to avoid higher-risk investments.
The graphic shows the difference in risk among asset classes and investments. Higher risk means investors will want to be compensated with a higher return, which is generally the case. Lower risk means lower returns but also less chance those returns are going to disappear in the next stock market crash.
Personally, I have a fairly high tolerance for risk. I still have just under 30 years to retirement, not that I’m sure I really want to retire, and income from several different sources. I understand the constant ups-and-downs of investing and that things will even out over the long-term, meaning my willingness is pretty high to tolerate a little more of those ups-and-downs.
Understanding your risk tolerance, and then investing accordingly, is the first step to finding balance and not really worrying about the next stock market crash.
Diversification against a Stock Market Crash
The second rule of investing is that of diversification. Diversification is so important that nearly every investor pays lip service to the concept even if few are really diversified in their investments.
To understand diversification, understand that there are different types of investments called asset classes. These asset classes; think big categories like stocks, bonds and real estate, pay out differently and react differently to the economy and other factors. Bonds are an investment in a loan, whether to a company or a person, and offer a fixed-level of return for a less risky investment. Since bond returns are fixed, their prices rise and fall depending on interest rates earned on new investments.
Some types of bond investments even offer a tax-exempt investing strategy that will save you money come tax time and grow your nest egg.
Stocks, the most popular asset class, are an ownership of a company and its future profits. Since those future profits depend partly on overall economic growth, the value of a stock rises and falls along with the economy.
The idea of diversification is that, since these different asset classes react to different factors, then buying investments in all of them means your overall wealth is not dependent on one group. Stocks may tumble in the next stock market crash but your bond and real estate returns will continue to provide stable returns. While the return on your bond and real estate investments might be limited, your stock investments offer the potential for growth when the markets are booming.
The graphic below shows the four major asset classes, along with some sub-classes, and the benefits and weaknesses of each.
There are more sub-classes within each major asset class but these will be enough to protect you from most of a drop in the stock market. Holding a mix of the sub-classes within each asset class gives you a huge level of diversification across different factors that will smooth returns over each year.
Your portfolio wealth may not surge along with your coworker’s who is invested completely in some hot technology stock, but you also won’t be left broke when that technology stock crashes.
You might notice that I haven’t included other traditional asset classes like commodities (energy, metals and crops) or alternative assets like hedge funds or venture capital.
An investment in these might not be available to many investors and they’re really not necessary for a diversified portfolio. You may get a little more diversification but holding the sub-asset classes within the main four are all most will ever need.
Instead of suffering a terrifying 10% plunge in overall wealth inside a week, the investor with money in each of the four asset classes may have seen their wealth fall by just a few percent.
As investments that offer a fixed-return if held to maturity, the day-to-day price fluctuations in bonds don’t really matter to most investors. You’ll get the same return as when you bought the bonds, regardless of what the stock or bond market does. Outside another major crash like we saw in 2008, your real estate investments will also not jump or plummet as quickly as stocks.
How much your overall portfolio of investments rises and falls along with the markets will depend on what percentage of your money you put in each asset class. We’ll go further into when to change your asset class percentages in a coming article but it really all depends on how much risk you are willing to accept.
Avoiding the Biggest Risks of a Stock Market Crash
One of the best new ways to diversify your investments is through peer to peer loan investing on Lending Club. P2P investing is just like investing in corporate bonds but the loans are to people instead of businesses. Despite some myths about the investment, peer loans are safer than stocks and provide steady monthly income.
I highlighted three Lending Club investing strategies in a previous post to show how different types of investors can take advantage of this new type of investment. From investors that need monthly income and low risk to those with a long-term outlook that want higher returns, there is a peer loan investing strategy right for everyone.
One thing to remember when investing in peer loans is that you should do so in an IRA or a Roth IRA account so your monthly interest is not taxed until retirement. It's these kinds of retirement investing tricks that will save you money and get you closer to your goals.
The best part is that peer loans help to spread your portfolio risk even more so you don’t worry about a stock market crash. Peer loan values do not rise and fall like stocks. They are more like bonds with a set return but pay monthly income.
While the risk of a stock market crash may be higher, it may not matter for long-term investors. Understanding these two basic investing rules is why I’m really not worried about the next stock market crash. Managing these basic ideas will help you avoid the majority of worst investing mistakes people make.
I don’t mean to sound shallow or detached. If you have been caught in the recent stock market selloff, resist the temptation to panic-sell everything or to rush in to bet on a quick rebound. Carefully look at these two simple investing rules in your investments and adjust your portfolio accordingly.