What to do in a stock market crash

What to do in a stock market crash

How should you react to extreme market turbulence? Throughout stock market history there have always been crashes and corrections, and there always will be. What's more, it's at precisely those moments of extreme turbulence that investors tend to make their biggest and most costly mistakes.

In this video, investment author Lars Kroijer explains how to react when markets fall sharply, and why the most important thing to do is look inward. The key questions to ask yourself are about your own risk tolerance, and whether anything has genuinely changed about your ability to predict or outperform the markets. The overwhelming likelihood is that it hasn't. Even in the depths of a crash, you still can't know what the market will do over the next twelve months. What may have changed, however, is your personal circumstances: a large loss can, paradoxically, leave you with a lower tolerance for risk, and that's a personal matter you should take seriously.

You'll learn why we're so prone to poor decisions at these moments. Human beings are hard-wired to react to recent events, and the bigger the event, the stronger the urge to act. Kroijer points out that investors have short memories, and that market history is full of selection bias, we tend to look only at the markets that survived and succeeded. Even 2008, as severe as it was, didn't end in the collapse of the banking system or the bankruptcy of governments. Panicking in the moment rarely serves investors well.

The video also explains why, since we can't predict the future, the best preparation for a severe downturn is diversification. Kroijer illustrates this by dismissing the fantasy of dramatic "safe havens" like gold bars in a vault, assets you likely couldn't transact when it mattered most. A broadly diversified portfolio of stocks is far more practical, because even in a crisis, there's a reasonable chance that some sector in some part of the world holds up better than the rest, preserving at least some value.

The takeaway: when a crash hits, resist the urge to react to the headlines. Look inward at your own risk tolerance and circumstances, remember that your ability to predict the market hasn't improved, and rely on a broadly diversified portfolio you've prepared in advance. That combination is the best defence against making your biggest mistakes at the worst possible time.

Chapters / Key points

• Why crashes and corrections are an inevitable part of investing
• Why investors make their biggest mistakes during turbulence
• Why your first reaction should be to look inward
• Assessing your risk tolerance and whether anything has really changed
• Why a big loss can genuinely lower your tolerance for risk
• Why we're hard-wired to react to recent events
• Short memories and selection bias in market history
• Why diversification is the best preparation for a downturn
• Why dramatic "safe havens" like gold bars aren't practical answers

Transcript

What to do in a stock market crash

Robin Powell: Hello there. Throughout stock market history, there've always been crashes and corrections, and there always will be. What's more, it's at precisely those times of extreme market turbulence that investors tend to make their biggest mistakes. Here's the investment author Lars Kroijer.

Lars Kroijer: So how should you react? I always say, well, a lot of that is about looking inward. What is your risk tolerance? Has anything changed to your knowledge about the markets and your ability to outperform the markets? The overwhelming likelihood is no. Whether it's now March 2009 and you've lost half your money, you still can't outperform the market, you still can't know what's going to happen 12 months in. But that doesn't mean that the climate hasn't altered your circumstances. You might paradoxically be that, as a result of a great loss, you have a lesser tolerance for risk. That's a personal thing, and you should treat it as that.

Robin Powell: The problem is that human beings are hard-wired to react to recent events. The bigger the event, the more likely we are to react.

Lars Kroijer: People have very short memories in financial markets, and people forget. Even if you look at financial markets over the past several hundred years, we will now look at the markets that were successful, there's selection bias. Once every so often there will be a huge calamity. How bad was 2008 really? Well, pretty bad, right? A lot of really awful things happened at the same time. But the banking system didn't collapse, no governments went bankrupt.

Robin Powell: The fact is, we can't predict the future, and investors should be prepared for a severe market downturn at any time. The best way to do it is to diversify.

Lars Kroijer: Should you have gold bars in your vault somewhere that you're going to go pick up, and in the case where that was a real store of value, would you actually want to wander the streets with these gold bars? Should you have bought a gold ETF? Well, in complete clarity, you probably couldn't transact any of these things, so they're not good answers. But, again, if you have the most broadly diversified set of stocks, there's some chance that some sector in some geography somewhere would have done just OK. So there probably would have been some value there.

Robin Powell: That's it. Thanks for watching.