Here’s why selling everything in a crash could be a costly mistake, what to examine in your portfolio, and how to prepare for opportunities when other investors become fearful.
Key Points
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Investors are concerned about the growing market risks.
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But individual companies can face very different risks during a downturn.
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Investors should prepare instead of trying to predict what’s ahead.
Investors have reasons to worry about the stock market. On one level, hotter-than-expected inflation data renewed concerns about further Federal Reserve rate hikes. The International Monetary Fund has also warned that an artificial-intelligence-related market correction or a sharp increase in government bond yields could trigger broader financial market turmoil.
And with the S&P 500 (SNPINDEX: ^GSPC) trading close to its all-time high, one question comes to investors’ minds: Should I sell before things get worse?
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Personally, I wouldn’t sell simply because a market crash is possible. Instead, I’d examine whether my stocks can withstand a downturn and whether their valuations leave enough room for disappointment. A market sell-off could punish speculative businesses, but it could also create opportunities to buy excellent companies at more attractive prices.
Investors are concerned about the growing risks
Risk management is an important part of investing, and currently three market risks deserve investors’ attention.
First, persistent inflation could keep interest rates higher for longer. Higher borrowing costs can squeeze businesses that depend on external financing, while higher bond yields can make stocks less attractive relative to bonds.
Second, the AI investment boom faces a test. Technology companies are committing enormous sums to data centers, chips, and computing infrastructure. If the resulting profits fall short of expectations, investors could reassess how much they’re willing to pay for AI-related stocks.
Third, valuations matter. When investors pay a premium for future growth — think AI stocks like Palantir Technologies or Space Exploration Technologies — even a successful business can deliver disappointing stock returns if growth slows or investors become less willing to pay a premium.
Having said that, investors shouldn’t get too carried away thinking that a crash is imminent. What they should do instead is monitor these risks over the coming weeks and make necessary adjustments to their portfolio.
Not every stock deserves the same response
Consider two companies facing the same potential market sell-off.
The first has a strong competitive advantage, recurring revenue, a healthy balance sheet, and the ability to generate cash through economic cycles. The second depends on cheap financing, burns cash, and needs continued investor support to fund its expansion. As borrowing costs rise and capital becomes harder to obtain, its financial position deteriorates.
In the event of a market correction, both stocks may fall, but the investment cases are very different. For the first company, the decline could create an attractive buying opportunity. For the second, the falling share price might reflect a genuine deterioration in its prospects.
For instance, almost all tech giants, such as Microsoft, Alphabet, and Amazon, experienced varying degrees of stock declines during the early COVID-19 shock in 2020. But since then, all three of them have reached new heights on the back of stronger financial performance.
Of course, these companies are just some of the positive examples, and not every company recovered in the same way. Think Peloton Interactive. The lesson here is obvious: While share prices and business fundamentals can diverge in the short term, they almost always converge over the long run.
Three steps investors can take now
Rather than trying to predict the next market move, I’d focus on three things:
1. Reassess your holdings
Ask whether each business can withstand weaker demand, higher financing costs, or slower growth. Pay particular attention to heavily indebted companies and businesses whose valuations depend on optimistic assumptions.
2. Think about diversification
Owning a concentrated portfolio, say three to five stocks, can induce enormous volatility in the portfolio in the event of a market correction. Investors should assess whether to diversify across more companies and industries to minimize exposure to any particular stock/industry.
3. Preserve your financial flexibility
Keep sufficient cash for emergencies and near-term expenses, and avoid excessive leverage. You don’t need to eliminate every portfolio loss, but you should avoid being forced to sell long-term investments at unfavorable prices.
Let’s be clear, though. These steps won’t prevent losses during a market crash. However, they could help you avoid unnecessary risks and make better decisions when opportunities emerge.
What does it mean for investors?
Nobody knows when the next market crash will happen. For investors who sell everything in anticipation of one, the risk is that they will miss out on further gains. At the same time, those who ignore deteriorating fundamentals could suffer permanent losses.
The better approach is to distinguish between businesses that are becoming more vulnerable and those whose share prices might fall despite resilient underlying economics.
I wouldn’t sell because I’m afraid of a crash. I’d sell when the investment case no longer justifies the risk or the price I’m paying for a particular stock. And if a downturn sends excellent businesses to bargain valuations, I’d want the financial flexibility to take advantage.
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Lawrence Nga has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Amazon, Microsoft, Palantir Technologies, and Peloton Interactive. The Motley Fool has a disclosure policy.
