Smart long-term investors have long understood how to take advantage of a stock market crash. 

Research shows that stock market crashes are inevitable over time. In the most recent downturn, after the S&P 500 peaked at $4,796.56 on January 3, 2022, it entered into a bearish run and closed at $3,674.84 on June 17, a 23% decline. The reasons why the market went down include geopolitical tensions in Europe, rising inflation and interest rates, and supply chain constraints. 

However, this recent market crash of the first half of 2022 is only one among many that have occurred in the past – and will occur in the future, to varying degrees. 

Just look at how many bear markets have occurred over the past 50 years. 

So, as a smart investor, you should not only expect bullish runs, but also the eventuality of bear markets – with special consideration on how to take advantage of a stock market crash. In other words, you have to think about what to do when the stock market crashes and how to respond to it. 

“If you’re going to invest in stocks for the long term, or real estate, of course, there are going to be periods when there’s a lot of agony and other periods when there’s a boom,” said Charlie Munger, vice chairman of Berkshire Hathaway, the conglomerate founded by Warren Buffett. “I think you just have to learn to live through them”.

In this article, we will consider five ways you can take advantage of a stock market crash for the sake of your financial goals. 

[Do you want to invest wisely in a way that helps you take advantage of stock market crashes? Register for our Sarwa trade app and/or investment platform, or schedule a free call with a Sarwa wealth advisor and we’ll answer all your questions.]

1. Apply dollar-cost averaging

Dollar-cost averaging is an investment strategy whereby you spread out the investment of a given amount over a defined period of time. So, if Mr. A has $10,000 and decides to invest $1,000 at the end of every month for the next 10 months, that is dollar-cost averaging. 

This investment scheme is often the preference of new investors who are not yet familiar with the market. However, it is also a good strategy for those who are cautious of investing a significant amount in the market at once. 

Dollar-cost averaging is also a good scheme during stock market crashes. How so, you ask? 

Well, when the stock market crashes, and the prices of stocks reduce, you are provided an opportunity to buy them at a cheaper price. For example, if stock A is worth $100 at the end of January and $80 at the end of February, investor A can buy them cheaper in February – and indeed would do so through applying a DCA strategy. 

For an investor practicing dollar-cost averaging, stock market crashes provide opportunities to get more shares for the same amount and to reduce the average cost of investing in a stock.

Let’s consider the example of Mr. A above who decided to split his $10,000 across 10 months at $1,000 per month. Let’s say stock A was worth $100/share at the end of January, $80 at the end of February, and $50 at the end of march. 

In January, he would get 10 shares ($1,000/100); 12.5 shares in February ($1,000/80); and 20 shares in March ($1,000/50). That is, the same $1,000 would get him more shares in February and March simply because the market was in a bearish run. Similarly, his average cost of investing in stock A would now be $70.6 ($3,000/42.5 shares) instead of the initial $100 ($1,000/10 shares). 

In the scenario above, Mr. A did not have to do anything. He just had to keep investing consistently through a dollar-cost averaging scheme. And now, he has benefitted from the market crash with more shares and a lower average cost.  

DCA vs avoiding the market vs buying the dip   

This dollar-cost averaging is preferable to holding on to your cash during stock market crashes. 

Why? Well, due to inflation, the cash you hold will be worth less by the time the market crash is over. 

Instead of holding on to cash that loses (real) value, investing in the market has the potential to get investors more shares for the same dollar amount and lower the average cost of a position in a stock. 

Similarly, dollar-cost averaging is preferable to buying the dip. 

Because no one knows when the market has truly reached its bottom – even expert analysts can never say for sure. If you wait for the dip, you have missed out on the opportunities to get more shares for the same dollar amount and lower average cost from dollar-cost averaging. Also, if the dip keeps getting lower, then you will continue to lose money. If you sell out of fear and the market begins to correct (uptrend), then you will miss out on that profit and will have to re-enter the market at a higher price. 

No wonder Callie Cox, senior investment strategist with Ally Invest, has said “buy the dip is one of those things that works really well on paper, but it doesn’t work well in real life.”

Dollar-cost averaging is a good way to avoid all the mess associated with buying the dip. 

2. Buy dividend stocks

Another way to take advantage of a stock market crash is to buy dividend stocks. 

Dividend stocks are stocks of companies that have consistently paid dividends for a defined period of time. Among dividend stocks, there are dividend aristocrats – those who have paid dividends consistently for at least 25 years, and dividend kings – those who have paid dividends consistently for at least 50 years. 

So, why are dividend stocks good in market crashes?

There are two ways to profit from a stock – dividend and capital appreciation. Unlike capital appreciation, which you enjoy when you sell the stock at a premium, a dividend is a constant, quarterly receipt of cash. 

Even during market crashes, most dividend stocks – especially the aristocrats and kings – continue to pay dividends. This is because these companies often have steady revenue and earnings since they are already at the maturity stage of their business life cycle. Consequently, they can weather inflationary or recessionary pressure and even increase their prices due to competitive advantage. 

So, the first reason to buy dividend stocks is that they provide a hedge against inflation and are more impervious to stock market crashes when compared to the general market. 

For example, while the S&P 500 index fell by 23% between January 3 and June 17, 2022, the S&P 500 Dividend Aristocrats index only fell by 16%.  

Secondly, with most dividend stocks, you will continue to receive dividends even during market crashes. This is cash that you can decide to withdraw or reinvest in the market to get more shares and lower your average cost (as with DCA). 

Moreover, some of these dividend stocks increase their dividend payouts during inflationary periods (since they can increase their prices and collect more cash from their sales), providing a hedge against inflation. 

“Large companies that have a long history of paying consistent dividends each year have something to their advantage in an inflationary environment: they can weather — and actually benefit — from higher prices,” according to CNBC. 

3. Consider re-evaluating your portfolio allocation 

Just as some sectors of the economy perform better during bullish runs, some also perform better during bearish runs. 

If your style of investing leans more towards active, then you can consider to re-evaluate your portfolio allocation. (If you are a passive investor, then you should be sticking to your portfolio allocation strategy even in a downturn.) 

Consumer staples, healthcare, and utilities are three examples of sectors that historically perform better during market crashes. This is because the products and services in these sectors (food, beverages, pharmaceuticals, hospital visits, electricity, water, and gas) are all-weather necessities, and people tend to keep spending money on them even when economies sour. 

Therefore, it is not surprising that while the S&P 500 Index fell by 23% between January 3 and June 17, the S&P 500 Consumer Staples Sector Index fell by only 11.5%, the S&P 500 Healthcare Sector Index by 14.4% and the S&P 500 Utilities Sector Index by 9.2%.

In contrast, the NASDAQ Composite Index, which tracks mostly technology stocks, fell by 31.8%.

So, instead of exiting the market, you can decide to push your investments from sectors that are less immune (technology, for example) to those that are more immune to the crash (consumer staples, for example). And when there is a recovery, you can re-evaluate again. 

This sector rotation is easier to implement with ETFs. An ETF is a basket of securities – many stocks (or bonds) in one. Therefore, if your investment in a sector is through a single ETF, rather than in 10 or 20 stocks, it is way easier (and cheaper) to sell one ETF and buy another instead of identifying, buying and selling multiple stocks in a sector that you may not be completely familiar with. 

4. Diversify with bonds

If your portfolio is not diversified beyond stocks, market crashes provide opportunities to correct that. 

“Every portfolio benefits from bonds; they provide a cushion when the stock market hits a rough patch,” said Suze Orman, founder of Suze Orman Financial Group. 

Bonds provide this cushion because they are not as volatile as stocks. And while the recent 2022 downturn saw volatility in the bond market, historically having a weighted portfolio with a good allocation of bonds (at least 20%) helps reduce overall risk.

Government bonds are still considered by many experts as very low-risk assets – that is, you can have more reassurance that they will pay. Even corporate bonds that are riskier than government bonds are still far less riskier when compared to stocks. 

Because of this safety, bonds are often preferred in market crashes, which makes them more valuable irrespective of why the market is down. That is, their prices can rise during stock market crashes when stock prices are falling. 

You can therefore take advantage of a stock market crash by investing in bonds and riding the wave of the bond market.  

5. Become a long-term investor  

While market crashes can and do occur, they don’t last forever. 

A recovery/correction period has historically always followed to date. Therefore, those who are patient and stay invested during market crashes are the same people who will enjoy when corrections occur. In contrast, “people who exit the stock market to avoid a decline are odds-on favorites to miss the next rally,” according to Peter Lynch, a renowned investor and the former fund manager at Fidelity Investments.

To take advantage of the rally after the decline requires a long-term investing perspective, the ability to spend time in the market rather than time the market. Studies by the Center for Research in Stock Prices (CRSP) have shown that the market rises more than it falls, also illustrated in the graph below. 

Therefore, those who stay in the market, rather than enter and exit numerous times, will earn more returns in the long term. 

Performance of the CRSP US total stock market index between 1926 and 2019 

In contrast, those who time the market might miss out on its best performing days while partaking in its worst performing days. For those who stay in through it all, however, there is more likelihood to profit since the market rises more than it falls. 

If you are a passive investor, you can create a diversified portfolio that includes dividend stocks, all-weather stocks in the consumer staples, healthcare, and consumer staples sectors, and bonds. 

You can also consider investing in such a portfolio using dollar-cost averaging. With a diversified portfolio, you can be confident in market crashes even without tweaking your portfolio. That is, instead of worrying what would happen if the stock market crashed, you can prepare for it beforehand. 

Sarwa Invest was designed for passive investors who want to create just such diversified portfolios. Our wealth advisors will work with you to create a diversified portfolio of ETFs (diversified across sectors, asset classes, and markets) that match your specific risk tolerance and time horizon, as well as by aligning with your financial goals.

[For more on how to invest in the UAE, read “How to Invest Money In The UAE: All You Need To Know”] 

If you are an active investor, you can also create a diversified portfolio of stocks or ETFs through the Sarwa trade app. And when market crashes do occur, you can tweak your portfolio to take advantage of DCA, dividend stocks, defensive sectors, and bonds. 

With Sarwa Trade, you can easily create your own portfolio, benefit from zero trading fees, and build it using all you have learnt about how to take advantage of a stock market crash. 

[For more on how to trade stocks profitably in the UAE, read “How To Make Money Trading Stocks: The Ultimate Guide”]

In the end, whether passive or active, the key is to stay in the market for the long term. As Warren Buffett said, “The stock market is a device to transfer money from the impatient to the patient.” Be patient, my friend. 

[Do you want to invest wisely in a way that helps you take advantage of stock market crashes? Register on the Sarwa app and take advantage of our investment products, or schedule a free call with a Sarwa wealth advisor and we’ll answer all your questions.]

Takeaways

• Market crashes will always happen as part of the stock market cycles. 
• Instead of exiting the market during market crashes, good investors should seek ways to take advantage of such stock market crashes.
• You can do this through dollar-cost averaging, dividend stocks, all-weather stocks in defensive sectors, bonds, and long-term investing. 
• Spending time in the market is more beneficial than timing the market since the market rises more than it falls