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What to do – and what not to do – in a financial crash

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The time to buy quality companies is when “blood is running in the streets”

Most financial crashes aren’t like crashes at all. A car crash or a train crash, for example, follows a predictable form: momentum carries the vehicle forward until it hits an object that puts a rapid, shattering end to the movement. It’s all over in a second.

Financial crashes, on the other hand, tend to behave like avalanches. They build up over time, and the longer they do so the worse they get.

A seemingly minor event may act as a trigger but avalanches feed on themselves: once the snow destabilises, forces build and the destructive path broadens. With a bull market now in its eighth year, Australians should be on avalanche alert.

It’s been 30 years since Black Monday, one of the few true financial crashes. Peak to trough, it took 17 months for the financial avalanche of 2007-09 to play out on the ASX. On Black Monday, however, the Dow Jones Industrial Average fell 23% in a single day.

By the end of the session, a record 600 million trades had been recorded on the New York Stock Exchange and the market had lost more than $US500 billion. In today’s terms, the same percentage downturn would have wiped off more than $US5 trillion from the market.

These are gut-wrenching occurrences but it’s important to see them in the broader context: over the long term, no asset class has done better than stocks.

Indeed, the Dow Jones went up fourfold in the 13 years following Black Monday – and that’s if you had bought the day before the crash, at the previous high.

Geoff Wilson, now chairman of Wilson Asset Management, who back in 1987 was based in New York City and working in institutional sales, remembers the period well.

“It changed everything. I was of the view it would take years and years for the market to recover. Amazingly, the Dow was up to its previous crash high after two years. It made me realise the time to buy is when blood is running in the street. To take a long-term view when investing, and work against your emotions.”

Black Monday is a reminder that fortune favours the prepared. It pays to educate yourself about companies and industries in anticipation of future opportunities because they may be short-lived. During the market crashes of 1987 and 2007-09, plenty of investors made mistakes, turning what should have been a once-in-a-generation opportunity into a portfolio disaster.

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Here’s your avalanche survival guide.

1. Don’t panic

Seeing your portfolio drop 20% or more is no one’s cup of tea but selling into the fear, hoping to time your way back in, is a surefire way to miss out on the market’s recovery.

If you’re jumping off the bandwagon at the same time as everyone else, you’re more likely to sell a stock when it’s undervalued. What’s more, unnecessary trading bites into your returns due to brokerage fees and taxes.

2. Don’t focus on current headlines

If any group knows how to make money during financial crashes, it’s the media.

To keep you reading, the news is framed to play on two primary emotions: fear and greed. Panics make that easy.

However, if you’re investing for the next 10 or 20 years, what happened in the markets today probably doesn’t matter too much.

Instead, focus on where a stock’s current share price stands relative to its intrinsic value, which is a function of all the cash it will throw off between now and judgment day. The book is long; don’t get too caught up in the current chapter.

3. Don’t travel up the risk curve

Psychologists have found that people experience the pain of losses twice as heavily as the pleasure of gains. Consequently, when dealing with gains, people tend to prefer a sure profit over an uncertain outcome.

When facing a loss, however, the opposite is true: people take a gamble, hoping to avoid it.

During crashes, this beast tends to show itself in two ways: investors buy “lottery ticket” stocks – small-cap companies, speculative miners, biotechs and the like – hoping to win big and make up for losses, or they shun diversification and bet the farm on just a few “trusted” companies. Owning a broad portfolio of stocks is less risky and more likely to produce satisfactory returns.

A market panic will probably create more opportunities than you can take advantage of, so if there’s one time it’s worth investing in a managed fund, it’s during a major downturn.

Fund managers are usually awash with opportunities and have more resources at their disposal, so can sort the gems from the rubble. Funds will also spread your money across dozens of stocks and reduce risk.

4. Always focus on value

Volatility is a source of opportunity if you stick to buying high-quality companies when they’re undervalued. And the best times to buy have been during market crashes.

Thirty years on from Black Monday, and with several market corrections since 1987 and now, including the more recent GFC, these are important lessons for all investors: focus on the fundamentals of what you are invested in, or are planning to invest in, and don’t let greed get in the way.

Written by Graham Witcomb

Graham Witcomb

Graham Witcomb is a senior analyst at Intelligent Investor (under AFSL 282288), owned by InvestSMART Group Limited. Graham has a degree in psychology from the University of Sydney and is a Chartered Financial Analyst (CFA) charterholder. He previously worked for one of the world's most successful professional gamblers, and joined the InvestSMART research team in early 2013. Graham's focus is on healthcare, insurance and transport infrastructure. To unlock Intelligent Investor stock research and buy recommendations, take out a 15-day free membership.

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