What’s your plan when the stock market crashes?

"Inaction breeds doubt and fear. Action breeds confidence and courage." Dale Carnegie

That’s one of my very favorite sayings, mostly because it’s true! In fact, usually when you are prepared for crisis, it doesn’t happen! The worst effects of any crisis will be felt by those who are completely unprepared for it.

What’s important is that you don’t panic. Stock market crashes happen — in fact, there have been three since 1987. Be aware of that, and accept that crashes are an “occupational hazard” for all investors in all markets. And just because a market is crashing doesn’t mean the sky is falling.

Panic is usually the given state of mind when a person is caught by surprise. But crashes shouldn’t surprise you, and you can take steps to help you to deal with it, while reducing the damage to your portfolio.

Sell stocks you think are overvalued

Whether or not the market crashes, you should never be completely out of stocks. Here’s the thing: a crash may come, but no one knows how severe it will be, or how long it will last.

This is also true about the coronavirus. We don't actually know yet how bad it will be, or if recent government measures are enough to stop the virus from spreading.

History teaches us the same thing. The 1987 crash came and went in a matter of months. In fact, the market turned north almost immediately after the worst of the crash. For this reason, you should never sell all of your stocks even if you fully expect a crash.

At the same time however, that doesn’t mean you shouldn’t make any changes in your portfolio whatsoever. If you have stocks in your portfolio you believe to be overvalued, now might be a good time to start selling them off.

This is especially true if you’ve already made a solid profit on them. If you think a stock is overvalued, there is a very good chance others will too and the stock will be especially hard hit in a crash.

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Invest for income

Since growth is the order of the day during bull markets, most investors concentrate on growth stocks and tend to ignore income. But this dynamic shifts in a crash. At that point, everyone is looking for income.

If you concentrate on income stocks — those paying above-average dividends — you have two advantages:

1. A steady income from dividends, to help soften the blow of falling stock prices, and
2. A strong likelihood of quick recovery in the price of the stock, because every other investor will be looking for the same type of investment.

Income stocks will not insulate you from stock price declines, but they will minimize the damage and make the ride a lot more comfortable.

Build up cash

Sooner or later stocks will stop falling — even in a crash. This will happen because they reach bargain prices — prices at which it will no longer make sense to stay out of the market. You’ll want to be prepared for that shift well in advance of when it happens.

The best way to do that is to have a large pile of cash available. Start building up that pile right now — it’s one of the most positive action steps you can take as a strategic reaction to a potential market crash. You can put your money in a high-yield savings account, or in a certificate of deposit offered by banks.

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Organize finances outside your portfolio

If a stock market crash hits, more than just your investment portfolio will be affected. Market crashes tend to be associated with weakening economies, and can mean a softer job market. It can negatively affect your ability to get a raise, or even keep your job. That is why you need to prepare your entire financial profile, and not just your investments.

Paying down your debts will open up options later, but more importantly, build up your emergency fund. This will be your best protection against a temporary loss of income.

Know that you will lose money

Despite your best efforts to prune and strengthen your portfolio, it is almost certain you will lose money across the board in a market crash. Prepare yourself now for that likelihood.

Your objective is not to prevent losses to your portfolio — that will be a wasted effort since it is completely impossible (short of selling off all of your stocks and moving completely into cash).

Instead, focus upon minimizing potential losses in your portfolio and accepting the reality that you’ll lose some money. This is one of the best ways to prepare your mindset to ride out the crash. These efforts are very doable, and well worth your time.

Remember: What comes down must go up

It’s practically a supernatural power to envision a brighter future in the midst of chaos, but that’s exactly what you need to do in a stock market crash. You have to train and discipline your mind to look past the crisis of the moment and plan for a still better future.

I actually become more optimistic about a situation during a crash. After all, the crisis is already unfolding and means recovery isn’t far-off. Markets do crash, but they also come back — often roaring.

Now that the market has crashed, it is time to start looking past the moment. Start preparing for the worst but expect that the best is yet to come.