Crash Anatomy 101: Market Decline Strategies Tailored To You

By TradeSmith Editorial Staff

Listen to this post
Markets take the stairs up and the elevator down.

And who doesn’t want to cash in on these swift moves?

When you see volatility ETFs like the UVXY up 38% in one day and 71% in less than two weeks, it’s hard not to feel left out.

But take it from me: Betting on market declines is a dangerous venture.

Instead, I want to help you find a strategy to capitalize on market declines based on your specific needs and investing style.

In my previous article, I explained how often pullbacks occur.

Sharp pullbacks of 5% or more occur about once a year. Corrections of 10% or more happen once every three years or so. Bear markets of 20% or more occur about once a decade.

So you should use this strategy sparingly.

Let’s start with a broad overview of how it works.

The Setup

Traditionally, investors split their money between stocks and bonds, usually something like 60%/40%, respectively.

That advice no longer applies.

Right now, bonds and debt products are at the highest levels they’ve been in years, and in many cases, ever!

While they might provide short-term relief during market declines, the long-term risk to the downside is too great to ignore.

That’s why I want to think about a portfolio in terms of stocks and cash only, leaving bonds completely out.

Consequently, if we are ignoring bonds, we have to either go to cash or wait out any market declines, whether they be short-lived like the one driven by COVID-19 or prolonged like the one caused by the Great Recession.

However, for folks who rely on their investments to live, both of these options can be a problem.

The S&P 500 took almost six years to recover from the market crash that started in November 2007.

So how do we handle this problem?

We want to ensure we have buying power in our portfolio, either by contributing regularly or by keeping a portion of our portfolio in cash (as much as 25%).

That might seem like a lot.

When markets decline, we want to use pullbacks to deploy more of our capital at lower prices.

Based on history, we know that market declines of more than 40% happen once every 25 years or so, while market declines of 20% or more happen a bit less than once every eight years.

We also know that while the market can take more than five years to recover from those major crashes, it can recover from those smaller bear market pullbacks in a little more than a year.

So we can aim to deploy that excess cash during pullbacks to help supplement our overall returns.

What to Do Based on Your Situation

Here’s how this might play out:

Suppose I decide that I’m ready to retire.

  • I have $1 million in my portfolio.
  • 75% of my portfolio is invested and 25% is in cash.
  • The stock market returns around 10% a year on average (from 1991 through 2020).
Now, if the market drops by 20%, with only 75% of my money in stocks, I take a hit of $150,000.

But because I have 25% of my portfolio in cash, I have the opportunity to lower my average cost of investment and increase my potential for gains by deploying some of my cash holdings to replace what I lost while stocks are “on sale.”

Recovering what I lost means I would actually have to earn 25% on my money (as opposed to the 20% I lost).

Note: Here’s the math. If I have $750,000 invested and lose 20%, I’m left with $600,000. Getting back to my initial $750,000 would require a 25% gain. But because I’ve reinvested what I lost with cash on hand, a 25% gain will take my investments to $937,500. With the remaining cash I have, that puts my total account value at $1,037,500, allowing me to recover from the loss faster.

Let’s see how this changes based on the different investor types.

ConservativeInvestors who are interested in capital preservation above all else.

The scenario listed above is how a conservative investor would approach market declines.

If you live off your investments, it’s important to set a stock-to-cash ratio that gives you enough money to pay for your living expenses.

As a conservative investor, you’re only looking to work with the broader market index ETFs like the SPY. You want to keep things simple and easy to measure.

ModerateInvestors who are willing to accept risk but don’t want to experience excessive volatility in their portfolios.

Most investors fall into this category.

The difference between moderate and conservative investors is that moderate investors aren’t as concerned about capital preservation.

Like conservative investors, moderate investors want to have a sizable amount of cash available to deploy.

Now, instead of limiting yourself to the SPY, you can look at sector ETFs or individual equities.

Generally, you want to look for areas of the market with relative strength — places that outperform others.

For example, during the COVID-19 downswing, large-cap tech turned first and outperformed overall.

During the Great Recession, financials took years to recover.

You don’t need to go deep into a roster of stocks to find some that work.

If large-cap tech is your choice, you can use the QQQ and XLK ETFs or get more specific with the SMH semiconductor ETF.

Ideally, you want to go with companies that turn a profit and aren’t valued based on earnings years down the road (as most electric vehicle companies are).

A great way to figure out which sectors work the best is by using market health indicators like those found in TradeSmith Finance.

These can let you know which industries are outperforming others and will be the first to turn upward.

SpeculativeInvestors who aren’t afraid to lose cash or take serious losses.

Risk and reward go hand in hand.

When you grab speculative companies, you have to be willing to lose what you put in.

So, using the same setup as the other two styles, speculative investors look for high-growth stocks, typically in burgeoning industries.

For this, we rely mainly on technical analysis, momentum, and storylines.

However, our goal is to get a chunk of the massive stock move, not the entire thing.

Think of SunPower (SPWR), which saw gains in excess of 1,000% off the March 2020 low of $2.94.

This stock’s incredible momentum was picked up by TradeSmith Finance when we triggered an entry to the Green Zone on Aug. 27 at $11.05.

The stock eventually stopped out at $23.61 on May 4, 2021, for a total gain of 113.7%.

That’s only a fraction of the total possible gains.

But guess what?

The S&P 500 only returned 19.5% during that time.

That’s the kind of return speculative investors can shoot for during major market crashes.

Final Thoughts

Many of us will fall into multiple investment types.

Just because someone lives off their investment income doesn’t mean they won’t have $100 to put into a speculative investment.

However, if you have to choose, err on the side of caution rather than risk.

Given what I’ve talked about here, what kind of investor do you consider yourself? Send me your thoughts here. I love to learn about my readers because it helps me create content that’s valuable to you.