The law of averages tells us that the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) will crash every seven to nine years, just like the USA's Dow Jones or the UK's FTSE.
An Eight Year S&P/ASX 200 rally
As can be seen in the chart above, Australia's S&P/ASX 200 has been in what the professionals would call a 'bull market' for around eight years. That's right in the middle of the bull market's average tenure.
The last major market event was the Global Financial Crisis (GFC), which was caused by people taking on way too much debt that they believed was 'low risk'. You can see in the chart above, Australia's sharemarket — referenced by the S&P/ASX 200 — fell 53% in around 18 months. Ouch. The Dow Jones also fell 53% while the FTSE 100 fell 47%.
But what exactly is a market crash?
Some experts define a 'market crash' as a 10% fall in the stock market in less than one day. Typically, further falls will follow which is why some people define a market crash as a 20% fall (or more) in one year. Because companies use the stock market to raise much-needed capital when times get tough, a market crash can have wider implications for the economy. More often than not, it leads to rising unemployment.
A crash is different from a 'correction', which is a 10% fall in one year. As you can see in the chart above, there have been many times in the past eight years when our market fell — yet it has steadily risen over time.
How to prepare for the coming crash
Make no mistake, a market crash is coming. There is no way to avoid it altogether or, as far as I know, how to tell when it will fall. The only way you can prepare for a crash is by ensuring your financial position is in top shape, meaning:
- No excessive debt (mortgages, car loans and credit cards)
- Keeping a cash 'buffer' for emergencies: Around six months of living expenses (rent/mortgage payments, utilities and food), and maybe an additional term deposit.
- Maintaining a well-diversified portfolio
That last one is particularly important because if you don't have a well-managed portfolio, you could be a forced seller in a market crash and that will severely hurt your financial goals.
Brinson et. al (1991) found that 90% of an investment portfolio's returns come from 'asset allocation'. That is, maintaining a mix of investments like local shares, international shares, property, cash and fixed income. Surprisingly, just 7% of returns came from picking shares and timing the market.
Some pundits debate this level of return, of course, but the fact remains, the way you structure your portfolio can have significant long-term implications on your wealth.
In my opinion, this is especially true when markets are riding high. It's important to keep a balance.
Foolish Takeaway
Market crashes are a fact of investing.
Maintaining a well-diversified portfolio is a great way to weather a financial storm. Personally, I think that once your living expenses and 'emergency' accounts are taken care of, the next step is to find quality shares to buy and hold for the long-term. Shares have been the best performing asset class over the past 40 years.
