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What to Do When the Stock Market Crashes

The answer depends on how close you are to retirement

By William Cowie | July 23, 2014

(This article previously appeared on Fivecentnickel.com.)
 
The Dow Jones Industrial Average index hit 17,000 last week — a new record — and the S&P 500 Index hit a record high July 3. As is usual any time a stock market record is reached, the boo-birds make their appearance.

“This is it!” they cry. “This is too high; a crash has to follow.” Well, something like that.

Of course, the boo-birds are right about one thing: The market always falls after it reaches a record high. The only problem is the market doesn’t drop immediately after each new record is set. It keeps going up … till it eventually does fall.

It always does.

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The history of the economy and the stock market are replete with cycles of booms and crashes. If you want to see a chart of the economy, you can click this link. The stock market cycles have the same wavy appearance. Both have the ups and downs we’ve become accustomed to, at least intellectually.

Whether you are active in the stock market or not, chances are it affects your wealth. Most Americans’ retirement funds —  in pension funds, 401(k) plans or IRAs — are tied up in stocks, directly or indirectly.

What should you do when the stock market crashes again?

In general, there are two broad answers, depending on how close you are to retirement.

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If you look at the stock index chart in the link above, you’ll notice the time between peaks (and valleys) usually is around 10 years. That means if you hang around and do nothing for 10 years, more or less, you’ll find yourself having recovered all of the losses a crash would have inflicted on you.

That makes 10 years a good cutoff point when considering your options.

10+ Years From Retirement

If you’re 10 or more years from retirement, do nothing. Well, not nothing. You actually keep on investing.

Warren Buffett, the world’s most successful investor, loves the periods when the market is down, because he always buys. And when the market is down, all his purchases are bargains. If you look at it like that, it makes sense.

The problem is that it’s hard to look at it like that. Why? Because we’re psychologically wired to feel good — rich, even — when we see the value of our investments go up. But you shouldn’t, for two reasons:

For one thing, the gain in wealth is unrealized. That means it’s not cash in your hand. And, as we all know, what goes up can come down. The only value that matters is the price when you sell.

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That often leads people to sell assets when their value has gone up, “to lock in the gain.” There’s a problem with that, though: If you sell your stocks, what do you do with the proceeds? You need to invest them somewhere else.

Therefore, there is nothing to feel good about when you hear the value of your investments went up, unless you have a better thing to invest the money in if you sell.

The other reason not to feel rich when your investments go up is: it’s a temptation to waste money. When you see the value of your investments soaring but your daily grind continuing unchanged, that creates a tension within you: “How come I still have to grind my little behind off, day after day, putting up with all the crud at work when I’m getting rich on my investments?”

Maybe your car is giving you trouble. Maybe your home appliances are beginning to cost money. Maybe your clothes just feel old and out of style. This tension between the unchanged daily grind and the reports telling you you’re getting rich has many faces.

But those faces usually all lead to the same temptation to spend money — buy a new car, a nicer home or new clothes, go on a shopping spree or a long-deserved vacation. We start using the “deserved” word a lot more when we see our net worth going up.

The bottom line is that, unless you plan to retire in the next few years, just keep on going on with your investing. If anything, try to invest more when prices drop.

Less Than 10 Years From Retirement

If retirement is less than 10 years away, things get a little trickier, because the odds are that the stock market will not have recovered by the time you retire.

However, if you think about it, what are the chances you’re going to liquidate your entire life’s savings the very day you retire? Small, I’ll bet.

You will be much more concerned with the monthly cash flow to cover your expenses. That means dividends and interest.

If dividends are your main interest, you should (again) be unconcerned with the movement of the stock market. If, for instance, you have invested in Dividend Aristocrats (S&P 500 stocks that have increased their dividend payouts for 25 years), your monthly income is safe. It doesn’t matter if the stock market drops because those stocks have proven their stability by paying growing dividends through at least two prior recessions.

In other words, if you are getting close to retirement, the focus of your investments should be shifting to stocks (and other investments) that will provide you with the monthly cash to meet your needs.

And, if you do that right, you won’t have to worry about the stock market dropping.

The next stock market crash is coming soon. Just how soon, nobody knows. But, whether you’re retiring soon or are still a ways away, there is no need to panic when that happens.

William Cowie spent 30 years in senior management (CFO/CEO) before retiring. He runs two blogs: Bite the Bullet Investing and Drop Dead Money and writes for the FiveCentNickel and Get Rich Slowly blogs, among others.