There is no standard definition for what exactly constitutes a stock market collapse, although the terms "bear market" and "recession" are both well-defined. Most stock exchanges have a circuit breaker in place to halt trading in individual stocks and the broader market when specific percentage declines have been reached. The first step is to recognize the scenario. Track economic data and commentary to understand what investment professionals and economists expect.
Understanding Investment Time Horizon
Reconcile expert expectations with the time horizon of your portfolio. Ideally, careful portfolio management prepares you for your worst-case scenario. One way of doing this is by managing asset allocation among asset class. The greater the length of time between the present and your expected retirement, the more risk you should be able to tolerate within your diversified portfolio of equity and fixed-income securities. Understanding this helps you avoid unnecessary portfolio turnover and associated transaction costs and tax expenses. If your time horizon is short, you should have a higher mix of cash and fixed-income securities relative to equity securities, which would mitigate the effects of a market crash. You can take comfort in the fact that your losses are unrealized until equity securities are sold at a loss. Over long periods of time the market has proven remarkably resilient.
Diversifying by Asset Class
Investing in asset classes or investments with negative or low correlations to the stock market should mitigate losses triggered by a stock market crash. Numerous sources for asset class correlation summaries are available online, although it is important to understand that these may change over time. Commodities, which can be inexpensively invested in via exchange-traded funds, tend to negatively correlate to common stocks. You may calculate your own correlation rates by taking time to learn how to find the formula for correlation in a spreadsheet toolbar and importing historical daily price information for two asset classes via exchange-traded funds, although the general correlation ranges available on the Internet should be adequate. Note that gold may not provide an effective hedge against stock and currency market fluctuations, as the price of gold is also volatile.
Timely Investment Strategy
A stock market crash can present a unique opportunity for an entry point into the market or specific securities. Historically, following the largest market declines hypothetical investors in the early stages of the long-term recoveries would have recorded very strong equity market gains. The proxy for expected long-term equity market returns in excess of a reasonable risk-free rate is the equity risk premium. There are several methods for calculating the equity risk premium, but you can easily obtain a reliable short-term and long-term equity risk premium online. The most sound strategy may be to do nothing. Another tactic is to use realized losses to offset realized gains for tax purposes if the opportunity arises.
Keeping a portion -- 10 percent, for example -- of your portfolio available in highly liquid investments may provide a safety valve in the event of a drastic market move. Diversification works in the long term, but stocks generally move in the same direction as the broader market indexes -- more so in times of crisis. Options and other speculative investments can be used to capitalize on abnormally large movements. Exchange-traded funds targeting "black swans" -- random and unexpected events -- also are available.
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