How To Avoid A Stock Market Crash

Someone joked, "That's Easy. Just wear 20-20 hindsight glasses."

Losing your hard-earned money in a stock market crash is no joke. Let's take a serious look at how to avoid a stock market crash that might severely affect your portfolio. I've tried to summarise in plain English, 14+ years of investing, trading, and observing the stock market. I've made and lost money - not millions - but just enough to feel the gain as well as pain. I hope you can gain from my pain. Here are some ways to not lose too much money in the market, in no particular order:


No dough in Dow

Question: What's the best way to avoid stock market crash?
Answer: Don't invest in any stocks or other securities that would lose value in a market crash.

Seriously. Let's say you took all your funds out of the stock market and deposited them in an Electric Orange℠ checking account from ING Direct and earned around 1% APY on that. After you moved your money from the market, let's say the market crashed by around 40%. Your net gain is 1 + 40 = 41%, not just 1% as some folks might want you to think.

Money not lost is money gained.

Here are some investment vehicles that are relatively safer than the stock market:

  • Invest in Private Lending The financial meltdown of 2008 has resulted in lower liquidity for banks. Even borrowers with credit scores above 700 are unable to obtain loans from traditional banks and are turning to established direct lending services like Lending Club. You could invest part of your funds in notes at Lending Club for 9% APY or better returns. You don't need to invest thousands of dollars, the minimum investment is only $25. The best way to invest in Lending Club is to start with an amount that you are comfortable with and then buy notes every month with 5-10% of your income - build your wealth slowly and steadily. Read my Lending Club Review to see how I netted 10-12% APY on my investments, with very low risk.

  • ING Direct Checking Account mentioned above. One of the best interest rates in the nation, plus your money is FDIC insured to the maximum limit set by the gov. No Fees.

  • Open a No-Fee IRA at OptionsHouse and invest your funds in a Money Market account within the IRA. Three advantages - first, no fees at all; second, a Money Market account preserves your investment and offers a competitive interest; third and most important, you get a tax break. For example, if you are in the 28% tax bracket and you invest $1000 in the no-fee IRA, you get a tax break of $280, which is equivalent to getting 28% tax-free profits on your money, and that too, when the stock market is crashing hard. Not bad at all. Again, your money is FDIC insured to the maximum limit set by the gov. Lending Club also offers a No Fee IRA.

  • Invest in a Money Market Fund (MMF) at OptionsHouse. While this is not FDIC insured, it's a relatively safe investment because a MMF's goal is to preserve your investment dollar for dollar. Apart from an MMF, you may choose to invest part of your money in a Bond Fund at OptionsHouse. Both MMF and Bond Funds pay you a monthly or quarterly interest.
    If you are not sure on which MMF or Bond Fund to pick, get a Free Membership at Morningstar Investment Research for in-depth reports and ratings on a wide variety of MMF and Bond Funds.



Always set a stop-loss

If I could write that a thousand times, I would. It's that important.

So, you research this stock for many days and find that the company is among the top performers in their industry and holds a promising future. You invest a good amount of money in it. One week later, the company announces some bad news and the stock falls steadily over the next few days. By the time you checked the stock, it was already down 40% from your purchase price. Sounds familiar? At least, it did to me. The lesson here is - no matter how thorough your research is, always set a stop-loss order right after you purchase a stock. This will greatly limit your losses, just in case of any bad news. And, believe me, there are many aspects that are not under your control, that can negatively affect the prices of stocks that you own.

Tip: Highly rated Online Brokers like TradeKing and OptionsHouse allow you to place two-faced orders for the same stock so that you can sell if a high or low limit is reached. For example, you can set a sell-for-profit limit of +10% of your purchase price and a stop-loss limit of -20%, in the same order. You can sleep well knowing that your stock would get sold for a 10% profit, or, you would lose at most 20% of your purchase price. This would help you avoid a stock crash, if something goes wrong.


Run Forrest... Run!

Most of you will know that I borrowed that line from the Oscar-winning movie Forrest Gump.

Apart from the fruit company that Forrest invested in and made a fortune, he doesn't relate much to the stock market, but the way he runs does - you should run away from the market when the time is right, and be prepared to keep running for many years like he did. Forrest grew his beard, and you will grow your money during those years, if you start running based on clear signs from, where else, the market itself.

If you have been a keen observer of the markets, you will find that in most instances of stock market crash, you would've had a smaller loss if you had followed the crowd and sold all of your long stock positions on Day1 of crash. Take a look at this example:

Stock price of Cisco (CSCO) on Sep 29, 2008, a high volume down day: 21.79, at market close.
Stock price of Cisco on Mar 9, 2009, when it started to turnaround: 13.62.

As you can see, you would've been better off selling CSCO in Sep-Oct 2008 at a 5-10% loss rather than suffering another 40% loss through Mar 2009.

The onset of a market crash is usually indicated by a huge down day where the major indices fall 5-10% or more. You can identify such days by the first few hours after the market opens: Extremely high volume - the first few hours would've traded way more than the average daily trading volume; steady and controlled drop of stocks across the board. Such down days are characteristic of the Big Boys exiting from their stock holdings and they are very likely not going to come back anytime soon into the stock market.

The large Mutual and Hedge Fund Managers, a.k.a. the Big Boys, exit in droves because they know very well that the market is not going anywhere but down for a looong time, so they would sell their stocks and park their funds in other safe places like cash, bonds, commodities, precious metals, or even stock markets of other countries. On such high volume steady down days, you would find that your limit sell order may not get filled, because by the time your limit order gets a chance to execute, the market price of the stock might have fallen well below your limit price. Once you detect such down days by the high volume and stock drop pattern, selling your long positions at market price is probably the best option, specially if you have a large number of shares to sell.

Couldn't sell on the first down day? No problem, sell on the second or third down day. You would still likely come out ahead. Why? Because the Big Boys wouldn't be able to sell their millions of shares in a single day. If they tried to do that, they would create panic in the stock market and a $500 stock would turn into a $1 stock and they still would hold millions of those shares, unable to sell them to anyone. So, they arrange a graceful exit spanning a few days. You too can exit with them on Day2 or Day3 at a decent price before the stock market crash goes too far.

So, Run Forrest... Run, to avoid a stock market crash.

Tip: Again, Online Brokers like TradeKing and OptionsHouse offer automatic trades that you can set to trigger when the Major Indices go down by a certain percentage. You can take advantage of this to make sure you sell on the first big down day to avoid a stock market crash, even when you are not near the computer.



Diversify

Never invest all your money in one industry, even if that's the best performing one at that time. This is because times can change - once hot industries can turn ice-cold in the future and you would lose all your money in such a stock crash. Even within an industry, always try to buy a basket of stocks, rather than just one. Why ? This is because individual companies can collapse due to mis-management even when other companies in the same industry are doing well. ETF's, or Exchange Trade Funds, are a good way to diversify your investments. Learn more about ETFs in the Free Education Sections of online brokers TradeKing and OptionsHouse.

Diversification among different industries and also among multiple stocks in the same industry is a very important tool to avoid a stock market crash.


Your Brokerage Account Balance $0.00

Why would you be looking to avoid a market crash? Mainly because you are afraid to lose a lot of money, right? So, if you don't want to be affected much by a market crash, you should invest or trade only with the amount of money that you are willing to lose completely, and still be able to sleep well at night. The exact amount is upto the individual, but a general rule of thumb is 10-20% of your net worth. Investing or Trading with only those funds you are willing to lose altogether is a cardinal rule of playing in the stock market, and is very much applicable in this context too.


Don't be a Cheapskate

Don't buy a stock just because it's cheap. It maybe cheap for a good reason. It would become even cheaper after you buy and you would lose money. So, stay away from cheap stocks to avoid a stock crash.


Sell in May and Go Away

Many of you would've heard this phrase related to stock markets. I would say, actually sell in March and go away. Gradually get out of your long positions in March and buy back in late August. Summer months are historically down months for the stock market because the Big Fund Managers that buy loads of stocks are on vacation. For the same reason, summer months are thin volume months in the stock market, hence could be very volatile times too - causing really wide swings in stock prices. The Fund Managers would return from vacations by end of August, and if you get back into the stock market by that time, you would see big gains when the Big Boys start buying stocks in bulk again.

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