While the stock market has been wobbly recently, it hasn’t ‘crashed’. The general definition of a crash is a fall of 10%-20% or more in the space of a few days and we haven’t seen that.
However, I wouldn’t rule out a major crash in the next year or two, as risks in relation to the global economy are growing. So, it could be time to think about risk management to ensure that you’re prepared if one does materialise.
Start with asset allocation
There are a number of ways that investors can prepare for a stock market crash. I think the most important move is to focus on asset allocation – the mix of asset classes in your portfolio.
This needs to match your risk profile. For example, if you’re planning to retire soon and will need access to your money (ie, you have less capacity to take on risk), it’s probably not a good idea to have all your money in stocks as they’re higher-risk assets.
How much of your money should you have invested in stocks? Well one rule of thumb that can be handy here is the ‘110 rule’.
With this, you subtract your age from 110 and the number you arrive at is roughly the percentage of your portfolio that should be allocated to stocks. For example, for someone who is 50, it would be 60% (the other 40% should be in lower-risk assets such as bonds and cash).
It’s worth noting that regardless of your risk profile, you should always have some cash in an emergency fund. Having a cash buffer will ensure that you don’t need to sell stocks in a crash to free up money.
Think about diversification
Another smart move is to focus on diversification at stock level. By allocating capital to different industries – including some lower-risk defensive sectors – it may be possible to soften the impact of a crash.
Some stocks tend to hold up quite well when markets fall. Consumer goods giant Unilever, which is less economically sensitive than a lot of other companies, is a good example here – it typically falls less than the market whenever there’s a meltdown.
Put together a buy list
Finally, it’s worth putting together a list of stocks that you’d like to buy if there’s a stock market crash. By doing the research beforehand, you’ll be more prepared for volatility, and ready to capitalise if brilliant opportunities suddenly emerge.
One stock I’d be keen to buy in a crash is Rolls-Royce (LSE: RR.). I’m not invested in this company today as its valuation spooks me (the forward-looking price-to-earnings (P/E) ratio is about 37).
But at the right price and valuation, I would buy it. For example, if the P/E ratio was 20-25, I’d snap it up.
That’s because I do see a lot of growth potential here. Not only does the company look well positioned to benefit from the increase in European defence spending (it makes engines for defence aircraft, land vehicles, and ships) but it also looks well placed to capitalise on the nuclear energy boom.
At 37 times earnings, however, there’s no room for an operational setback. For example, if the civil aerospace side of the business has a hiccup, the share price could drop sharply.
So, I’m happy to wait for a better buying opportunity.
