How to prepare for a stock market crash

Warren Buffet is accumulating a great deal of cash at the moment. After selling more of Berkshire's equity portfolio, including massive portions of its stakes in Apple (AAPL -0.52%) and Bank of America (BAC 0.72%), the company ended the third quarter with a record $325 billion in cash and Treasury bills on its balance sheet. That's up $48 billion from the previous quarter.

His trick has always been to buy good companies at a low price and hold. It seems he is getting ready to buy again which perhaps means he is expecting to see a bear run and can buy good companies at a cheaper price.

WB doesn't see much gain in top quality large companies at the moment. They seem overvalued. Small/mid-cap companies are not worth his time and effort (he could buy them all outright if he wanted with $48 billion). So I think he is expecting a bit of a correction but meanwhile is probably earning a nice 5%+ on his cash pile whilst he waits.

So what should we do if the SHTF?

Bear Markets

We have seen many stock market recessions (20%+ dips) in the last century and four in the last 20 years.

We can see that they take up to 2.5 years to recover, but they eventually do recover and are followed by bull markets and strong gains.

So, if you are currently investing (i.e. putting money into investing), the best thing to do is to keep investing (dollar cost average) during a recession into ETFs. You will be buying stocks at a cheaper price and thus you will recover more quickly when the following bear market eventually comes along. Don't worry that the value of your pot is decreasing but smile as you are buying really cheap stocks every month.

Retired?

However, if you are retired and are drawing down on your investment pot, it is a different story. You might have 60% of your pot in market shares and 40% in cash (bonds or Money Market funds). So it might be a good idea to sell some of the equities ASAP - at least enough to outlast the dip. Then as equities start to recover, buy them back again at a lower price (perhaps in large monthly chunks to spread the buy cost)? In practice, this is difficult and you could end up buying the same stocks at a higher price than you sold them at.

If your pot has been reduced by 60% (say) once the recession has ended, you will need to rebalance your portfolio. Say you had 100k and after drawdown for a year and with the recession your pot is now only worth 60k. Then you might like to put 50k of that 60k into equities and just 10k cash/bonds/MMF once the bull run recovery starts. After a year or two, you could then build back up your cash pot and reduce your equities.

The widely accepted advice however is to never sell your stocks. In this case you might have 60% in cash/bonds/MMF and just 40% in dividend-earning stocks. You will be living off the interest from the cash and also the dividend payments from the stocks. During a recession you may need to draw off some extra cash, but don't sell the stocks. When the market picks up again and your stock portfolio value recovers, and you can then rebalance. To do this, your pot must be big enough so that 4%/yr is enough to  live off.

Typically equity values will plunge in a recession and your dividends may be reduced, but you simply have to hang on until things pick up again. Hopefully, you won't need to dip into the 'cash' part of your pot to top up your income, but you can if you need to.

It all depends on what your living expenses are and how big a retirement pot you have. It may be wise (and cheaper!) to consult an independent financial advisor who specialises in retirement. Anyone approaching retirement should have already done this 3-5 years before they retire anyway.