How Do You Survive A Stock Market Crash?

A reader writes:

“Hi Nords, I have some fears about a market crash that would derail early retirement. If I retire now in my late 40s, it would be near impossible to get my job back in my line of work. It’s almost easier to retire even earlier… Because then one would not be too old to re-enter the workplace.

You’re right about extreme early retirement. I know several early retirees in their 30s (and one in their 20s) who are confident that they’ll be able to freelance their way to more income if they need to. But if you can accumulate the assets to retire early, you might always produce income through some entrepreneurial project.

My spouse and I have been through two “market crashes” during our early retirement: the tech recession of 2001-02 and the Great Recession of 2008-09. We’ve invested since the late 1970s, but both retirement recessions felt more painful because we were no longer covering our expenses with a paycheck. Today, though, we have the experience and confidence born of the crucible. Another recession wouldn’t bother us much, but we might find excellent investment bargains.

Fear

The biggest challenge of a recession is dealing with emotions: particularly fear. The first coping defense for your emotions is an asset allocation that helps you sleep at night. (Then you can lie in bed reciting the Bogleheads mantra “Stay the course!” until you doze off.)

But seriously, watching your portfolio meltdown through a recession is a test of mental toughness and stamina.

Can You Recover From a Stock Market Crash?

In a word, “yes,” you can.

The variables are how long it takes and how well you recover. Also, understand that the longer you’re in the market, the more you learn. That applies to your successes and your failures.

In other words, if you’ve been through a stock market crash before, you’ll learn valuable lessons that will lessen the pain if and when it happens again.

Defining what a stock market crash is is somewhat arbitrary, but to put things in perspective, if the S&P 500 drops 7% in a single day, trading may be halted for 15 minutes. This is like calling a time-out to let cooler heads prevail.

Individual stocks are often halted based on news that affects a company’s stock price (e.g., a bad earnings report), but the entire market has been halted only a few times in its history. In most cases, the market moves 1-2% at most in a single day.

In general, market crashes are emotional and, most of the time, reasonably short-lived. Understand that financial markets that are usually rational can behave irrationally, often based on world events such as the threat of war, economic news, and so forth.

Overall, the U.S. stock market has proven remarkably resilient in the long term. It routinely recovers from short-term crises and rises over longer time frames.

For example, from 1940 through 2020, the S&P Index has produced an average annualized return of more than 11%.

The key to recovering from a market crash is not to panic. Staying invested during crises may seem counterintuitive, but it often turns out to be the best move.

How to Prepare for a Market Crash

Take several proactive steps to minimize a market crash’s impact on your assets.

Asset Allocation

With an asset allocation plan, you can feel in control.

When you rebalance during a recession, you’ll buy more bargains at the bottom of the market. That confidence keeps you from panicking and selling out at the worst time.

When done right, diversification can insulate you in most cases. You can work with a financial advisor to align your investments and allocations with your goals. You may want to go with a “set it and forget it” strategy, such as investing in a target-date retirement fund (as many 401(k) plans allow) or using a robo-advisor with built-in diversification.

If you prefer to invest on your own, you MUST do your homework and adjust as you go. But don’t get antsy and overcompensate based on short-term events. The best investing is done long-term and without panic.

Recession Investing

A second defense is educating yourself about asset allocation and recession investing. It’s more than following directions from a few excellent websites or books; it’s understanding the principles behind the advice and appreciating market history.

I started with Dimson & Marsh’s “Triumph of the Optimists” and William Bernstein’s excellent “The Four Pillars of Investing.” You can browse more books from the “investing” and “retirement” categories on the blog’s “Recommended Reading” list. It doesn’t matter what you read about asset allocation and recession investing as long as you read enough to react, “Ho-hum, another swing of the pendulum.” Then turn off CNBC, step away from the computer, and go for a long walk.

Oddly enough, it also helps to share the misery when you’re afraid. One (free) approach is to post in financial independence forums where everyone is worried about the recession. You’ll see some posters buying gold bullion and shotgun shells, but the experienced investors will be waiting for their criteria to rebalance their portfolio.

You’ll also find plenty of reassurance. Other investors hire financial advisors just to have someone to hold their hand and tell them that everything will work out fine.

If you’re so inclined, be ready to buy on the dip. That’s where fortunes can be made over the long term.

Risk Assessment

Everyone has a different risk tolerance based on several factors. Your age, the size of your assets, past investing experience, and whether you invest with the help of a stock advisor or on your own are just a few variables.

Another factor is your emotional quotient. Fear and anger can color your investing experiences negatively. Fear and anger can color your investing experiences negatively.

Can you treat investing as a business proposition, or do you get emotionally involved with how your money is invested? Practical and logical approaches work best.

Financial Resources

The next challenge is financial: having the assets to survive a recession. Most recessions bottom out during the first year and start recovering during the second, so my spouse and I keep two years’ expenses in cash.

We start every January with about 8% of our portfolio in CDs and a money market fund, and we spend it on our expenses. At the end of the first year, if the market is up, we replenish the cash stash from dividends/interest or by selling a few appreciated shares.

If the market is down at the end of the first year, we start cashing in the CDs. By the end of the second year, we might have to contemplate selling equity shares, and they might be off their peak value, but we’ve never had to sell at a loss.

Another financial defense against a recession is longevity insurance. Every retirement portfolio should include some annuitized income, even if it’s “just” Social Security. When you reach financial independence, if you don’t have a pension, I strongly recommend creating one for yourself: plan for Social Security or put 20%-25% of your asset allocation into a single-premium index annuity. You’ll get a steady monthly income no matter what the stock market does.

If you’re reluctant to trust an insurance company (and pay the fees for longevity insurance), I’d recommend a low-expense dividend equity index fund, a balanced fund, or even rental real estate. (We have a portion of our portfolio in the iShares Select Dividend ETF DVY.)

During the Great Recession, our dividend fund lost nearly two-thirds of its value from peak to trough, but its dividend payouts only shrank about 30% from their peak and then began to recover.

A year later, its share price was back near our cost basis, and it’s risen steadily ever since. (When we rebalanced our portfolio, we bought more shares.) Today it’s above its 2007 levels, but dividends have grown faster than U.S. inflation (and much faster than our inflation!).

Landlords lost equity during the Great Recession but did well on cash flow because many tenants were former homeowners. Other disciplined, diversified dividend investors who held on during recessions (selling only if a company froze or cut its dividend) saw minimal income reductions.

For even more stability (and less effort), you could buy a balanced fund like Vanguard’s Wellington or Wellesley, which combines bond income and stock dividends and automatically rebalances its holdings.

Variable Spending

Another financial defense against recessions is variable spending. The 4% Safe Withdrawal Rate withdraws 4% in your first year and then increases annual withdrawals with inflation each year after, but those assumptions are easier for a computer to simulate. No human robotically follows that system.

Investor behavioral psychology suggests the wealth effect pushes us to spend more in bull markets and cut spending in recessions. If you find yourself tempted to boost spending during a bull market, you could try raising your cash asset allocation to 9-10% at the end of the year to give you a little more buffer during the next contraction.

You will also spend less during a recession, so your two years of cash for expenses will probably stretch to 2.5 years or even longer.

In “Work Less, Live More,” Bob Clyatt pioneered the 4%/95% version of variable spending. (Look for the book at a library.)

Bob’s system withdraws 4% of your portfolio value every year, no matter what that value may be. There are no inflation adjustments, and a 4%/year withdrawal works great during bull markets. However, if the portfolio drops during a recession, you’d have to take a huge spending cut next year.

That’s where the 95% comes in: if the market is down at the end of the year and next year’s 4% withdrawal would be an amount of money less than 95% of last year’s withdrawal amount, then cut back your spending to 95% of the previous year’s withdrawal amount. (Your withdrawals will only shrink 5%/year when the market drops.)

This means you might end up withdrawing 5%- 6% of your portfolio per year for a couple of years during the recession. Still, eventually, the market will recover, and your portfolio will rebuild. Bob hired a financial analysis firm to run the historical simulations (just like the 4% SWR). He brought his financial independence portfolio through the Great Recession in the same way.

Bob’s “Armageddon” solution is a temporary job, even if it’s through a temporary employment agency or running errands on TaskRabbit. However, since writing WLLM, he’s rekindled his passion for art, and he’s now one of NYC’s leading sculptors. When you’re financially independent, you’ll probably find a passion (or at least a paying hobby) that also helps you feel more productive and confident during recessions.

Mine is writing & blogging, and I could pull in at least $25K/year by working 15 hours/week. The FinCon personal-finance group has hundreds of entrepreneurs doing at least that well.

Recessions during financial independence are just part of the economic cycle. Mild recessions happen once or twice a decade. More significant recessions happen once every few decades. Statistically, you may be fearing a market crash that may never occur. Here’s the crux of the 4% SWR: at least 18 out of 20 times, you end up with way more money than you need.

Since we’re all (mostly) human, we immediately disregard the wins and zoom in on the 1 or 2 failures with laser-keen focus. We try to reduce that to “0 out of 20” by various schemes like “just one more year” or “the 3% SWR” or “living off the dividends and never touching the principal.”

However, the best way to avoid those rare failures is with annuitized income from Social Security, an SPIA, or dividends. The other winning situations will take care of themselves!

How Long do Stock Market Crashes Take to Recover?

There are three levels of crashes to consider, and in part, that determines how long recovery can take. Every downturn is different, so every recovery will be different.

Pullbacks are dips of 5% to 10% from a recent market high; they’re short-term, lasting an average of a month and taking another month to retrace the losses. Pullbacks are fairly common, happening about once a year since World War II.

Corrections are drops between 10% and 20. They’re characterized by high volatility with rapid buying and selling as panicked investors unload their positions. These market falls tend to last four months on average and take about that long to recover.
Crashes are downturns of more than 20%. They’re almost always the prelude to a recession and can last anywhere from one to two years. Recovery can take as long as five years to recoup market losses.

Making Money During a Stock Market Crash

You can make money during a crash if you’re a contrarian investor. It feels counterintuitive, but experienced investors have made fortunes by reading market forces and having the risk tolerance to bet against upturns. By shorting stocks, you’re betting on a market downturn.

Another way to make money during a crash is to buy high-quality blue-chip stocks from companies that generate real profits and attractive returns on equity, have low-to-moderate debt-to-equity ratios, strong gross profit margins, and shareholder-friendly management.

You can also use dollar-cost averaging, which means buying and selling at fixed intervals and with set amounts of money. It protects you from the lowest lows but limits your ability to cash in entirely on the highest highs.

There’s no sure bet for making money during every stock market crash, since the factors shaping each downturn can differ. However, as a general rule of thumb, stocks in “defensive” sectors such as industry, finance, and health care usually rebound well during a recession recovery.

Another strategy is known as sector rotation. This means moving money from one stock market sector to another. For example, tech stocks tend to do well during times of high growth.

When the economy slows, stable, boring sectors like utilities tend to hold up better. So if you strategically rotate between them, you may avoid large dips in one sector. This goes against the idea of sitting tight, but many people use this rotation strategy and do quite well.

You can also play defense if you’re close to retirement. Consider shifting your portfolio away from volatility by investing in bonds, dividend stocks, and reliable, low-risk mutual funds with limited stock exposure. This slows growth but helps prevent large losses in a major downturn.