How to Profit from a Stock Market Crash – a Simple Strategy
From this, we will learn how to make a profit from the stock market during the stock market crash. It also includes what we should not do during the crash, personal finance tips, how to pick a company to invest in. All these topics are discussed in the following. First, one being stock market history, rare opportunities the market provides during the crashes, how to prepare yourself to earn a profit during the market crashes, grading factors, etc.,
The Stock Market Crash Of 1929
This crash happened almost 90 years ago, but it’s lessening are still relevant today. This is the biggest market crash ever recorded in the history of the stock market where the Dow Jones average fell by almost by 89.19 percent in a period of fewer than three years. It fell virtually from its peak at 81.2 to a low of 41.7. This enormous drop was by far the biggest in the history of the stock market. The leading causes for this fall were
- Speculation where everyone invested
- Buying on Margin which allowed money from brokers, so they only need to put down 10 or 20 percent themselves.
- No regulations in the stock market yet which caused a vast bubble to inflate.
- During the 1920s the stock market grew up by nearly 20% a year reaching the peak in August 1929 by then the production declined, unemployment has risen, stock prices were overvalued compared to the intrinsic value.
Among the other significant causes of the fall was struggling agriculture sector, access to jumbo bank loans that ‘couldn’t be repaid. Billions of dollars were lost in this crash wiping out thousands of investors, machines ‘couldn’t handle the tremendous volume of traders. It took Dow Jones 25 years to recover, i.e. from 1929 to 1954 which recovered from peak to peak. This is the most prolonged recovery period in an average in the history of the stock market. During this dividends were not taken into account as in those days the dividends would be only between 4 to 8 percent. Considering these dividends would be reinvested then the recovery would have been not so long but would be only a decade or so, which is very less than 25 years. One of the people who earned money during 1929 was Erwin Kahn, who said in his words, “During the depression, I could find stocks trading at tremendous discounts. I learnt from Ben Graham that one could study financial statements to find a stock that was a dollar selling at 50 cents. He called this a Margin of safety and its still the most important concept related to risk. It’s important to know that even during the most significant stock market crashes, it is possible to make money. Though the times were different back then, no access to knowledge related to analysis compared to current day tools and analysis. In present times we are equipped with the right expertise to know how to act during a stock market crash.
This is the market crash of 1987 which is also called as Black Monday. During these crashes, stocks almost fell 20% in a single day which is the most significant single-day drop in the history of the developed stock market.
The leading causes for this crash were the market and economy were moving apart from each other for the first time in the active bull market of the ’80s. The valuations of stocks rose to P/E ratios of well above 20, estimations for future earnings, future profits were lower, which did not affect the stock prices. A lot of stocks were overvalued. The most significant element that contributed to the crash was that many institutional investors were well aware of this problem. Portfolio insurance/ trading programs led many to ignore these warning signs. The institutional investors ignored these warning signs as they fell, thinking their trading systems will be able to protect them from the crash. However, as soon as the stocks started to decrease computer programs automatically began to sell shares, ascertain loss targets were hit, pushing prices lower. The lower prices fuelled more selling which is a 22 percent drop in a single day. The systems which were thought of protecting from the fall were turned out to be a weapon of destruction because all programs did the same thing at the same time. With such a massive crash in a short amount of time, how long did it take for the Dow Jones to recover? It took just eight months to recover from such a massive single-day crash. Instead of selling the stock during the crash but hold on to it, 18 months later, one would have been at the same price level as before. In the meantime, we would have made a profit in the form of dividends. This is a perfect example of why one would need to hold on to one’s investments and in fact, investing more during these crashes. One could doubt about investing during the market crash, but it is the period where one can earn profits. Since the crash of 1987, which is 30 years ago, the Dow Jones is more than a 1000 percent, i.e. (1011 %) which is 20,533 points that turn our investment ten times higher.
1999 Dot-Com Bubble
This bubble is a perfect example of how irrationality increase in case of the massive stock market crash. This bubble was caused mainly because of the rise of the internet, i.e. the reaction of investors to the increase of the internet. From 1995 to 2000, NASDAQ, a technology stock index rose from 1000 points 4500. The primary causes for this crash to happen was
- Hundreds of internet-based companies that did not earn a dollar of profit IPO’d.
- Investors blindly threw money at every internet stock they could find the capital money available in massive amounts which did not even earn a profit.
- Access to cheap credit, overconfidence, and hype, which resulted in stocks, became hugely overvalued.
- No other time in the history of the stock market saw more significant differences between stock prices and their intrinsic value.
- Traditional valuation methods like P/E, P/B, P/CF ratios and discounted cash flow calculations got thrown out of the window. NASDAQ lost 78% of its value as it went down from 5064 to 1114.
Financial Crisis 2008
This is the most devastating recessions since 1929 where the whole economy took by a massive hit which also left millions of people unemployed. Dow Jones index went from a little over 14000 in October 2007 down to 6400 points on March 6th, 2009. So the market lost 55% of its value. Around every developed market collapsed during the 2008 financial crisis and that put the whole world in a significant state of emergency.
Several big players started to sell their stock during this time, which caused mass panic in the market. By the end of 2001, many of the publicly traded dot-com companies collapsed where trillions of investment capital evaporated. With such a massive crash, how long did it take to reach its peak again? It took about 15 years to get back to its previous highest peak. Considering the current days’ height (2017), the value increased to more than 375% (2002 to 2017). This shows the opportunity that the crashes provide. The leading causes of these collapses are
- Cheap access to credit
- Financially unqualified people could quickly get a mortgage/subprime mortgage.
- Housing bubble eventually, people started to default the subprime mortgages for banks.
- A Larger amount of houses foreclosed which however happened fast such, in no time a more significant amount of homes being foreclosed was a reason behind the massive drops in housing prices. Banks those hold these houses ran into massive losses because of a big domino occurred in the financial market where credit dried up. O
- One of the primary reasons is that financial institutions could take on excessive amounts of debts, thereby leveraging themselves would increase the damage.
- Many big financial institutions who were exposed to instruments called Credit Default swaps as they could no longer be paid insurances to banks because of the insane levels of leverage.
- All the above factors caused to even more credits being dried up. Looking at the AIG scale in the picture below what happened during this period
People stopped buying anything, the lot of companies had meager earnings causing the stocks to drop of course. Even from this extreme crash, the market could recover in a certain period. As the market hit a low in March 2009, the prices started to increase again. In 2013 it took a high which was during the period in October 2007 again. This made the recovery time of about six years. If one had invested money during these periods or near the bottom of the crash, it would be more than 200 percent. We can see from the worst crash from the last seven years we can learn a lesson.
During the Brexit panic, we can consider this as a massive stock market crash which serves as a perfect example of how the market can be volatile in recent times. The leading causes of this crash were the British voted in a referendum that Great Britain should leave the European Union (EU). Investors wholly caught off guard, predictions were in favour of Britain, that will not leave the EU, but that was proved to be wrong. This unexpected outcome resulted in panic in the global stock markets and indexes around the world fell from 3 to 10 % within a single day. Some stocks from the UK fell more than 20%. In this process, 2 trillion US dollars got wiped out in a single day.
One hundred largest ‘companies’ stocks from the UK fell by 6% in a single day. The exciting thing is the stock market recovered fast that within a week the level rose up again more than the previous peak. This extremely fast growth helps us to know how soon the stock markets can recover and how quickly we need to be as an investor. Therefore it’s essential for us to get ready with a plan during these kinds of crashes occur. A stock market crash will happen again that we ‘don’t know when and how big it would be. But it will happen again. So, we need a plan in place where it helps us take advantage of opportunities stock market crashes provide. Everyone around us is panicking and fearful where we can learn a general lesson where we can act appropriately. When we invest near the bottom of the market crashes, when we buy where others are selling, we can make huge profits. With this, we can know that stock markets provide once in a lifetime opportunities when these kinds of crashes occur.
Rare Opportunities Stock Markets Provide
Most people like stock prices when they high which makes some sense because they can earn some money on their prior investments. However, when you are not close to retirement and still have many years of investment left, and you have some money on the side available for investing, then you should always prefer low stock prices over high stock prices.
When you are a buyer of stocks, you are better off buying at low prices, just like the way you buy your groceries, new shoes or a car. Lowest stock prices are much more favorable as long as you ‘don’t have to sell stocks anytime soon. But just because we are human, heart-wise. We pick stocks of high prices which makes us feel better. It is crucial how psychology plays a role in investment plans. So many things here are related to analytical skills with which we can control our emotions. That is the reason why the many intelligent investors lose the money in the market simply because they sell the stock because of the fear. They sell right when they should be buying. This huge difference is what separates highly intelligent individuals from highly smart investors. The most successful investors look at the stock market crash as one of those rare opportunities when you can buy quality merchandise for dirt cheap prices.
Preparing to Profit from a Stock Market Crash
The plan for profit during the crashes are divided into 3 phases.
- Financial Preparation
- Mental Preparation
- Research / Wish List Preparation
When we are ready with these preparations, we can say we are fully prepared to take advantage of the low stock prices that come with the stock market crashes. However, if one of those events is not fully developed, we can make some severe costing mistakes which many investors have before. Remember to go in fully prepared plan and not a half-prepared ideas.
Having cash on the sidelines available to invest during a market crash puts you in full control of taking advantage of the opportunities that present themselves. Two steps that we need to prepare ourselves financially are
- Have an emergency fund in place. Always and often, the stock market crash goes hand in hand with economic trouble. You never want to be forced to sell your stocks because you need cash in order to pay your bills. Keep emergency fund covering at least 3 to 6 months worth of living expenses where we do not need to stress about money or well being of the family for financial security.
- Keep a sideline bucket. Each month put a small percent of your income aside and put in your sideline bucket.
On an average of every 2.1 years, the stock market drops 10%. Every seven years the market drops at a 30% rate. This will happen again in the future, but we cannot guess when, but it will happen. Always be prepared financially at any time to take advantage of crashes when it does happen. Therefore we need to have a sideline bucket. The important part is to automate this bucket so that each month a small piece of your income (about 1 – 3 %) is being deposited in this account. It is recommended to separate this sideline bucket from the rest of the regular savings or savings accounts. It cannot be suggested that you postpone your monthly investments. These strategies are being followed by great investors and the famous one being Warren Buffet. During 2008 crash he made some massive investments in blue-chip companies which he took advantage of the situation using his cash power. Those investments made him 10 billion dollars.
Every time a market crash occurs, a couple of percentages of investors getting scared by investing forums being getting messages about selling all of your stocks right now. So, a sense of widespread panic is immediately noticed in the stock market. The hard thing, however, is it does affect our need which is normal for human beings are hard-wired to follow the crowd. This behavior exactly is what destroys investors in the stock market; therefore ‘it’s important to protect ourselves from the widespread panic. So, how should we go on to prepare mentally for these situations and make sure that we are able to keep our head cool with others around us are panicking? A simple solution to this is to write a letter to yourself a letter of rationale which sounds a bit weird, but it really works. When the stock market crashes, its hard to stay completely rational, to in the letter which can be small sentences tell your self that this creates a great opportunity. Fortunes were made during this crash. Tell yourself that the majority of the investors do not understand this, and they are driven by fear. Everything they are facing is driven by fear. They are selling where they should be buying. Tell yourself that the great investors like Warren Buffet are buying the stocks right now and they are not selling. Tell yourself that you minimize the time watching financial news feeds or spending on investing forums where everybody is spreading fear. Tell yourself that use your money from the sideline bucket that recovery comes and you will come out of this crash and become a whole lot richer. Follow your plan, and you will be doing what 90% where all other investors ‘won’t be able to do. Because of reading this letter, we could get the courage to invest with confidence. This really works writing a letter to yourself and do not think this is a stupid thing.
This is the last stage of preparation before any stock market crash occurs to get an advantage out of it. If you are able to act fast during a market crash, you must know beforehand what companies you want to invest in. All great investors around the world have a wish-list of companies that they want to invest in, but that seems too expensive right now. They soon invest in those companies as the stock market crashes when the stock prices drop. We need to update this list all the time that may give us clarity before investing in it. What companies should be on your wish-list?
High-quality companies are companies that are able to withstand an economic downturn. This means they must be financially healthy, the economic moat that protects profits. There must be predictable and recurring cash-flows.
Companies with exceptional management teams who must be of high quality skilled must be experienced, must live up to their promises, and they must be in-line with their shareholders.
Companies with the highest profitability margins in their industries. It means
A high net margin
High ROA, ROE, and ROIC
High free cash flow margins
High gross margins
High Operating Margins.
We should look for the companies with these characteristics, make sure you invest in high-quality companies which are well set to return a high amount of profits for many years, with the stock market crash. This means the price will increase in exponentially faster than that of comparatives.