Secrets to Making Money During a Stock Market Crash
A Time When Fortunes Are Made
Fear of a stock market crash is never far away. Thanks to 24-hour news cycles and the constant bombardment of social media, every piece of small data seems like a monumental reason to begin trading shares in your retirement or brokerage account. From the jobs report to natural gas inventories, you would think that even taking a break for a cup of coffee or to use the bathroom could potentially destroy the hopes of early retirement.
The powerful truth often repeated in financial circles is that making a lot of money doesn’t require a high IQ, either in the market or in business. It takes ruthless cost control, a disciplined routine, and a focus on doing what is right for the long term. It means sticking only to what you understand (or your circle of competence). Whether you are running a McDonald’s franchise or managing your 401(k) from your home office, investing should be, as Nobel prize-winning economist Paul Samuelson put it, "like watching paint dry…If you want excitement, take $800 and go to Las Vegas.”
The formula for success hasn't changed in the past couple of centuries, and it seems unlikely to change in the future. Here are five rules for making money during a stock market crash.
Rule No. 1: Buy Into Good Businesses
Buy shares of good businesses that generate real profits and attractive returns on equity, have low-to-moderate debt-to-equity ratios, improve gross profit margins, have shareholder-friendly management, and have at least some franchise value. These firms hold up better under stress, making recovery more likely even if the share price declines by 75% or more.
Rule No. 2: Follow a Formula
Dollar cost average into and out of your positions, buying and selling at fixed rates and set amounts of money. This will allow you to avoid buying a position at a peak or selling it at a bottom. You're never going to be able to time the market, so stick to a routine policy of regular share accumulation or liquidation.
Rule No. 3: Reinvest Your Dividends
Reinvest your dividends because it will supercharge your dollar cost averaging program. The work of renowned finance professor Jeremy Siegel has shown time and again that reinvested dividends are a huge component of the overall wealth of those who made their fortunes investing in the market.
Rule No. 4: Watch out for Fees
Keep your costs low. Though it may seem insignificant, there is a big difference between earning 7% and 8.25% on your money. For a 25-year-old investing $5,000 per month into a Roth IRA with hopes of retiring at 65, the 7% rate of return will get them around $998,175 by retirement. The 8.25% return will result in $1,383,610 in wealth. That’s $385.435 extra, or 38.6% more money. Place the difference into municipal bonds and you get an extra $17,000-plus in after-tax income each and every year without touching your principal.
Think about that—the same investment, with only slightly higher returns, is going to get you an extra $1,400+ per month in after-tax retirement income without ever having to touch your portfolio. Before taxes, that would be about $2,300 in gross pay when you were working a nine-to-five day job. Put another way, getting that extra 1.25% return over 40 years is like receiving a $27,600 annual pay raise during your working years. The big difference is that you won’t have to deal with scheduled hours, a boss, co-workers, or a commute to collect your municipal bond interest.
Why talk about a 1.25% difference? That’s the management fee charged by most actively managed mutual funds. An index fund, alternatively, just buys and holds a basket of stocks established to mirror an index—most often, the S&P 500 or the Dow Jones Industrial Average. With almost no maintenance expenses, the fund costs are a mere 0.12% of assets per year, or $120 for every $100,000 you have invested. The two most popular index funds are offered by Vanguard and Fidelity (check the prospectus for the current expense ratios).
I’ve seen one major wealth management firm offer an S&P 500 index fund that requires virtually no work, but charge a 1% (or higher) expense fee each year. That’s 10 times the cost of the Fidelity and Vanguard funds for a virtually identical product. You’ve already seen what the implications can be to your pocketbook over a few decades. Most investors don’t realize the importance of fees because the money is automatically deducted from the mutual fund itself. In other words, they don’t have to write a check so it's a case of “out of sight, out of mind.”
Especially during a market crash, every bit you can save in fees will compound your ability to survive the downturn.
Rule No. 5: Have a Backup
Finally, the last secret to building your fortune when Wall Street is in a storm is to create backup cash generators and income sources. This is one of the single most important things you can do to cut your risk. Even if you are an attorney earning $300,000 per year or an actor making $2,000,000 per film, you are going to have a much more enjoyable life if you know that you aren't dependent upon your next paycheck to maintain your standard of living.
Consider the method of legendary investor Warren Buffett, known as the Berkshire Hathaway Model. This method makes it far easier to amass the first few million dollars in net worth. In essence, you live off your day job, funding your retirement out of your regular salary. Then, you build other cash generators (e.g., car washes, retail stores, newspaper routes, a lifeguard job during the summer, patents, royalties, rental houses, etc.) that you use to build your investment portfolio. That way, while you are doing your regular thing—going to work, picking up the kids, having staff meetings, and putting gas in the car—your cash generators are pouring money into your brokerage, retirement, and other investment accounts.
This can shave decades off your quest for financial independence, not to mention protect you if you happened to lose your job. Think about Warren Buffett. If Dairy Queen were to go bankrupt, he would still be rich from Berkshire Hathaway's ownership of GEICO. If that were to go down, too, he still has Nebraska Furniture Mart. If that were destroyed, there's always Benjamin Moore Paints. If that were wiped away, he could always fall back on Coca-Cola. In the unlikely event that Coke ceased to exist, there's always American Express, Duracell, Wells Fargo, U.S. Bancorp, Fruit of the Loom, Borsheims, and Berkshire Hathaway Energy.
All of this started with a paper route that provided his initial capital more than 70 years ago. Consider the small backups you can begin building into your financial plan today. Funding your investments from a variety of sources will better position you to handle a stock market crash.