A stock market crash can be catastrophic for your personal finances. The best way to protect yourself from a stock market crash is first and foremost by becoming a value investor. Next, you should take the following three concrete steps:
- Thoroughly Investigate the company’s business model, quality and integrity of its management, company’s past performance in terms of profitability, liquidity and solvency, length of the uninterrupted dividend-paying history and so on.
- Determine the intrinsic value of the shares
- Buy stocks/ shares only at or below their fair price
Well, how are the above steps going to protect you from a stock market collapse?
Scenario1: Situation in a Stock Market Crash when Shares Bought/ Held Below Fair Value
The answer is simple. Let us suppose that:
- You have found that a wonderful company that is worth keeping in your portfolio issues a particular stock.
- You have determined the stock’s intrinsic value is US$ 1.02.
- The stock market collapse has brought down the price of the share to say, US$ 0.40.
- You hold 500 pieces of the particular stock at an average holding cost of US$ 0.57.
Or are you staring at an opportunity of buying a share worth $ 1.02 at $ 0.42, a whopping discount of 59%? In this situation, you have not lost $ 50. Please see the calculation below:
Actually, you have a great opportunity in front of you to buy stock worth $1.02 at $0.40. If you buy 500 shares at $0.40 you will bring down your average holding cost to $0.46 and this is called dollar cost averaging.
Whether you buy more shares at the beaten down price or not, having bought shares below the fair price as well as the intrinsic value, you are safe. You do not need any additional protection.
Now let us explore a situation in a stock market crash where a person bought stocks far above their intrinsic values.
Scenario2: Shares Bought/ Held Far Above the Fair Value
Now suppose Mr.Generous had bought the same stock at various prices ranging between $1.50 to 2.50 and the average holding cost of his 500 shares is $1.75.
In this scenario, the stock market collapse has seriously eroded Mr.Generous’s investments by 74%.
If he holds onto his investments and sits tight through the storm, even Mr.Genourous does not lose anything. Only if panics and sells he will take a big loss.
However, even if doesn’t sell, having made the grave mistake of purchasing the shares far above their intrinsic value, his investment is always at risk.
You can protect yourself and be in a safe and happy zone in the first place by keeping wonderful companies in your portfolio (see a list at Portfolio2K15) and secondly only by buying these shares at prices below their intrinsic values.