This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
With the stock market officially in bear-market territory, it's only natural to wonder just how bad things could get before we hit the bottom. Indeed, while 2022 has been rough on the stock market, thus far this year, the worst single day in the S&P 500 was only a 4% decline. That's not even enough to trip the market's "circuit breakers" to put a temporary pause on trading. While the decline has been painful, it hasn't been a full-on rapid market crash, with all the instant wealth destruction that entails.
In other words -- it could still get worse, should the market end up outright plummeting from these levels. Despite that ugly potential, there are at least three reasons not to worry about a stock market crash, as long as you're prepared for one to come your way.
1. You have a decent emergency fund in cold, hard cash
Although inflation is eating away at the purchasing power of your cash, the reality is that a market crash can destroy far more value in a day than even currently elevated inflation rates can destroy in a year. In addition, serious market crashes often bring severe job losses along with them.
If you lose your job during or just after a market crash, or otherwise face a crisis while the market is down, then an emergency fund can give you some much needed buffer. A reasonably sized emergency fund -- around three to six months' worth of expenses -- won't keep you afloat forever, but it will buy you some much needed time.
That cushion can keep you from being forced to sell your stocks in the middle of a very rough market. After all, your bills don't stop arriving just because the market is down or you lost your job. Not being forced to sell shares near their lows, thanks to an emergency fund, can make all the difference in being able to participate in any market recovery that follows.
2. You don't need to sell your stocks to cover your near-term costs
If 2022 has done anything useful for investors, it has reminded us that stocks can go down as well as up. This is why money you'll need to spend within the next five years or so does not belong in stocks.
Instead, money you know you'll need to spend within that time frame should be in cash, CDs, or high-quality and duration-matched assets such as Treasury investment-grade bonds. To be clear, you won't earn much on those types of investments, but there's a much higher likelihood of that money being there when you need it. Just like an emergency fund, these assets can keep you from being forced to sell while the market is down just to cover your costs.
The other benefit this approach gives you is that it goes a long way toward helping you keep your wits about you when the market is crashing. To support the long-term thinking needed to stay invested while stocks are down, there's nothing quite like knowing you don't need to spend the money you've put into stocks in the next few years.
3. You're not using margin to invest
As long as you're not using margin to invest, the mere fact that stock prices are falling rapidly won't require you to sell your positions. If you are using margin, however, falling stock prices can trigger a margin call, which could force you to sell while your positions are down.
When a margin call takes place, your broker can liquidate any position in your account. During a margin call, your broker doesn't care about the long-term prospects of your investment, whether you're facing a capital gain or a loss, or anything else of value to you. All the broker cares about is closing out the call and eliminating your obligation. As a result, a broker-enforced liquidation could not only keep you from participating in any recovery that follows, it could also cause some nasty tax consequences as well.
Margin is truly a double-edged sword, and it's also a tool your broker uses to stack the odds in its favor. Not only does your broker collect interest when you take out a margin loan, but that broker can also change the terms of the margin agreement. Often, that involves setting terms more strictly after a stock has fallen, which can force a margin call or make an existing one worse. It's tempting to use margin in a rising market, but when (not if) the market falls, your losses can easily more than offset any gains.
Putting it all together
If all three of these statements currently apply to you, it will be much easier for you to ride out a market crash; indeed, you might even be able to take advantage of a crash to buy great companies at cheap prices. If, on the other hand, you're missing out on one or more of them, there's no time like the present to get yourself ready.
Whether or not the market plunges soon, the reality is that it will crash again at some point. Getting yourself prepared before it happens will put you in a much better spot than you'll be in if it crashes before you're ready. So put your plans in place today, and you may be able to dramatically reduce your worry about the state of the market.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
