How to prepare for a stock market crash — before it’s too late

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For a while now, I’ve thought that the riskiest parts of the stock market are the companies that look like AI beneficiaries but actually aren’t. And this week’s suggested that might be right.

Investor/hedge fund manger Michael Burry’s been getting ready for an AI-induced crash by going short on Nvidia and Palantir. But how should investors who don’t want to do that protect themselves?

Selling out

One strategy involves selling investments. But the vast majority of the time, I don’t think this is a good idea. The main reason is that it’s hard to know when to buy back in and the cost of being too late can be high.

When share prices fell in April, they recovered in less than a month. Since then, they haven’t really looked back and even if the S&P 500 falls 20% from its 52-week high, it will still stay above its April lows. So trying to sell before a crash is a risky business.

The exception is if not selling before a crash means you’re likely to have to sell during one. In that case, it’s better to think about getting out while prices are higher.

Enduring

I think a better plan is to treat a stock portfolio like a property. If you own a house, you should be aware that the market might shift and it could be worth less next month than it is today.

You’ll want to be prepared for this possibility. But that doesn’t involve selling your house before a market crash with a view to trying to buy it back again when it’s cheaper. 

What you need to do is make sure that you can’t be forced into selling your house when prices are low. And this has much more to do with your other finances than your property.

The same goes with stocks, with one major difference. As well as your own finances, you also need to think about the companies you’re invested in.

Resilience

International Consolidated Airlines Group (LSE:IAG) currently has a leverage ratio of 0.8. That looks like a sign of a strong financial position, but this can change suddenly.

The company’s main costs (fuel and staff) don’t depend on passenger numbers. As a result, profitability can fluctuate sharply as travel demand waxes and wanes.

This means the firm’s leverage ratio – which measures its cash profits against its net debt – can also rise and fall sharply. If demand falls away, profits can drop and the ratio can go up rapidly.

A firm’s balance sheet shows its financial position at a specific point in time. But investors need to be aware that how things are in the future can be very different to how they are now.

Being a good investor

Being a good investor involves being prepared for a crash. And I look to do this by making sure I’m not going to find I have to sell when prices are cheap.

With investing, I also have to look at the financial strength of the companies I own shares in. And this is why IAG isn’t on the list of stocks I’m looking to buy right now.

There’s potential for long-term consolidation in the airline industry, which could be positive. But I worry about the impact of high fixed costs on the firm when things go wrong.

The post How to prepare for a stock market crash — before it’s too late appeared first on The Motley Fool UK.

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More reading

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Stephen Wright has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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