Joe Moglia, Contributor
Oct. 11, 2021
Investors of all stripes have been benefiting from an unprecedented bull market since the March 23, 2020 low caused by the first wave of the coronavirus pandemic. Not only that, but 2021 became the year of meme stocks when retail investors, sharing information on Reddit, rode otherwise moribund stocks like Gamestop up on a surge of excitement and animus towards institutional investors and hedge funds. It can seem like everyone is making money. Yet no bull can run forever. Eventually, the market will crash, and we’re seeing some plausible causes already.
In China, the debt crisis surrounding real estate developer Evergrande threatens economic stability, and there is a risk of potential global financial contagion. Some observers fear the collapse of the company, which has some $300 billion in outstanding bills , could be China’s Lehman Brothers moment. And in the U.S., inflation is on the rise and the Federal Reserve must walk a tightrope in tapering bond purchases and raising interest rates . Too fast, and it could threaten the recovery. Too slow, and inflation could climb further still. For retail investors, it’s important to be prepared for a potential downturn. But there’s a right way and a wrong way to plan for a bear market.
The first thing to remember is that day traders tend to do well in bull markets—when assets overall are rising—and poorly overall when the market is falling. The reason for this is simple; when the market is going up you tend to make money, and when it’s going down, you tend to lose it. At the same time, retail investors probably can’t tailor their investments to macroeconomic forecasts. In fact, it would frequently be a mistake for a retail investor to change their investing behavior because they believe there is going to be a crash.
There are two reasons for this.
On the one hand, the big players—institutional investors like banks and hedge funds which have their own teams of economists working full time—will have already priced macroeconomic shifts into their strategies. By the time worries over a downturn hit TV, the big players are typically already in front of it, leaving few effective avenues for smaller investors.
And on the other hand, if retail investors go to cash expecting a crash and it doesn’t materialize, then they’ve left potential gains on the table. After all, every day somebody is talking about how the Fed will push the economy into recession, there’s someone else saying the exact opposite. Trying to guess what’s coming next is no different than putting your money on black. Maybe you’re right. But maybe you’re not.
So what should retail investors do to make sure they’re protected when a crash actually materializes?
Know your strategy
The best way to protect yourself during a downturn is to have a strategy and stick to it. That strategy should be clear and easy to follow. Before you make an investment, have a plan for when you will begin taking profits off the table. If you enter a position at $10 and it goes up to $15, for instance, trim that position by 10 percent and put your returns into another asset, either another stock, bonds, or cash. If it goes to $20, trim the position by another 10 percent. (These numbers are just examples; each investor will need to work out their own strategy.) This takes discipline because it is always tempting to keep riding it up, but it’s easy to get stuck with it on the way down.
Manage your risk
Use stop loss order s. If you buy at $10, put a stop loss at $9 to guarantee you’re not losing more than 10 percent. Then, if it goes to $15, for example, put a stop loss at $13 or $14. That way, if it falls, you’ll still walk away with some profits and control your potential losses. It’s also important anytime you invest to have a clear idea of how much you can afford to lose if the market moves against you.
Using basic trading tools like stop loss orders and sticking to a disciplined investing strategy are two key ways that retail investors can protect themselves from a potential crash. It’s also important to be diversified. This means a mix of stocks, bonds and cash. It also means diversity within the equities themselves. You need exposure across industries and regions. One of the best ways to do this is to own the S&P 500. That way, you’ll automatically own multiple sectors and most of the companies will have significant exposure outside of the U.S.
At the end of the day, the best way for retail investors to play a crash is not to play it at all and instead focus on a well thought-out, disciplined trading strategy. And it’s important to remember that it’s never wrong to accumulate a cash balance. If things are going well and money is coming in, don’t feel like it all has to be invested. Sometimes the right move is to just put it aside.
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