Four Steps to Prepare for a Market Crash

This article is published with permission from InvestmentU.com.

It is Wall Street legend that in 1979 BusinessWeek informed readers of “The Death of Equities” right before the biggest run-up in stock prices in history.

Since then, many other magazine covers have served as a contrarian signal for where the markets are headed. That’s led to a theory among some investors that the market is about to do the opposite of whatever mainstream magazine covers suggest.

This week, for example, bears are celebrating and bulls are cowering after Time magazine explains “How Wall Street Won” five years after the financial crisis, complete with a bull in a party hat.

However, the cover (and article that goes along with it) can hardly be described as bullish. What the bears are conveniently ignoring is the subhead, which reads “Five Years After the Crash, It Could All Happen Again.”

The article goes on to describe how the big banks have become even larger and the whole too-big-to-fail mess could repeat itself.

So devout followers of the magazine cover theory shouldn’t hit the sell button just yet.

But for the sake of argument, let’s pretend that Time’s cover is wildly bullish and did send a legitimate bear signal to the world. Or maybe tapering will sink stocks. Or Mercury in retrograde will depress earnings… What would be the proper course of action for investors in a bear market?

Four steps to prepare for a crash

1. Understand your time horizon

If you invested 10 years ago for an event this year, you might seriously consider selling your stocks and converting them to cash — but that’s regardless of where you think the market is going. If you need the money in the short term, it doesn’t belong in the market. If you have longer than a few years to invest, don’t worry about a crash as long as you…

2. Make sure your stops are in place

The Oxford Club recommends a 25% trailing stop loss. The stops protect gains as stocks rise and ensure that no single position results in a devastating loss. Since stocks are up so much over the past four years, even if you do get stopped out, you should get out with a profit. This strategy also ensures that you have plenty of cash to get back into the market at lower prices. During the financial crisis, Oxford Club Members were stopped out of positions in 2008 and took profits on many stocks that had risen during the previous bull. That freed up capital to get back in during the lows of 2008 and 2009, resulting in some huge winners, including Discovery Communications (Nasdaq: DISCA), up 255%, and Diageo (NYSE: DEO), up 171%.

3. Review your portfolio

If you haven’t done so in a while, take a look at the stocks in your portfolio. Make sure the companies are still operating at a high level. If you own Perpetual Dividend Raisers — stocks that raise their dividend every year — examine when the company last raised its dividend. If the company is continuing its streak of annual dividend raises, generally speaking, you should be fine for the long term.

4. Be ready to buy when things are bleak

It takes a lot of guts to buy stocks when it feels like the market is falling apart, but that’s how the biggest gains are made. Whether you’ve raised capital by selling stocks whose stops were hit, or you have money set aside, buy stocks after a market slide. You might not catch the bottom, but since stocks go up over the long haul, getting them at a discount will add significantly to your returns.

Regardless of the predictability of the magazine cover theory or any other signal, long-term investors should not get caught up in the day-to-day market noise. You will make money as long as you don’t panic in the face of a sell-off.

Marc Lichtenfeld is a senior analyst at Investment U. See more articles by Marc here.

The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.