Thursday, January 27, 2011

How to deal with a stock market crash

In an earlier post "Next time I won't sell', we reviewed the theory behind 'Buy and Hold" strategies.Today's post shows how you could have benefitted in real life from the 2008-2009 crash.

The graph below shows the performance of the S&P TSX from Jan 2008 until today (Graph is from GlobeInvestorGold).  The TSX peaked in April 2008 but when comparing from the start of 2008 until now, one may conclude that we have now fully recovered. Add to that a 2-3% dividend return per year and we would have made money especially when including the dividends

The graph shows perfectly why you shouldn't panic during a market crash, when you own a diversified portfolio such as represented by the here often quoted Ishare ETF of the S&P TSX60 (symbol: XIU). There would have been no loss as long as you didn't sell during the crash with the proceeds deposited in a money market fund. Your net value on paper may have been down during 2008 - 2009, but all that is now recouped - as long as you didn't sell.

Timing stock market events doesn't work - nobody knew in April 2008 that we were at a peak; neither knew anybody that March 2009 was the bottom - I certainly didn't!  Only if you make a habit of taking profit when a market looks expensive and buying when prices are attractive would you have done better. Looking backwards gives you a 20/20 eyesight, but it also illustrates how to make money in stock markets. If you had held on to a portfolio of XIU shares and bought steadily more after the market was down 30% without knowing when the exact bottom occurred, you would have bought at the right price and your overall portfolio would have outperformed the market handily.

You would need to have cash to buy those shares during the market crash and that shows the importance of good cash management. Had you accumulated cash when the market started to look expensive by not reinvesting dividends while taking some profits from time to time on the way up then you would have been ready to buy when stock prices became attractive during the crash (a little bit at a time).

Stock market investing is not rocket science. But it takes discipline to carry out your investment plan and to  believe that the world won't come to an end no matter how bleak the short term outlook. Stock market crashes have occurred many times and none of them caused the world to end. So, at the next crash you know what to do, but do you have the fortitude to buy when everyone around you sells?

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