How do you protect yourself in case of a market crash? What are the biggest shocks when it comes to investing? The big drops in the stock price or the company going bankrupt?
I’ve come up with 4 strategies that would make you immune to both of the scenarios.
1. Educate yourself and make sure you know what you are doing
When you choose a company to invest in, don’t do it because some guy on the internet told you so or you saw the news on TV.
You have to learn to evaluate a company and buy shares only from good companies. You have to learn to pay less than the value that you receive.
A good starting point is this series of articles that I’ve written for beginners. Even if you are a seasoned investor, don’t ever forget the basics.
2. Cost averaging
You buy 1000 shares with $10 per share at company X. The cost is $10000.
The share price drops to 5$. The uneducated ones get scared, sell the stocks frightened by the thought that the price would drop even more, and lose $5000.
The informed people like yourself after reading the “Education”
section of this website did everything by the book and know that there is no chance for company X to go bankrupt. The price drop is circumstantial and has nothing to do with the value of the company.
So, instead of selling, you should celebrate the fact that you are able to buy value stocks at a lesser price. You buy another 1000 shares at $5 per share. That costs you $5000. Now you own 2000 shares that cost you $15000, an average price of $7.5 per share. Your average cost went down.
The unfavorable circumstance passes by and the stock price reaches $15. You sell and cash in the 100% PROFIT.
The uneducated investors didn’t do their homework on step 1 and have lost $5000 because of the shock. You, on the other hand, were smart and took advantage of the situation, securing a bigger profit.
3. Cash is king
And I’ve learned that from the best. Warren Buffet reveals in “The Essays of Warren Buffett: Lessons for Corporate America”
– by Lawrence Cunningham
that Berkshire Hathaway always has at least $20 billion cash to take advantage of opportunities that might present themselves at any moment.
A lot of people say that there’s inflation, money would devalue, that even a bank can go bankrupt and other misbeliefs about “sitting on cash”. But if you wouldn’t have cash, you couldn’t take advantage of the opportunity as it was presented in the scenario from above.
4. Diversification. But within boundaries.
No matter how well you’ve done your homework, you can’t eliminate 100% the risk for a company to go bankrupt.
People don’t know how to make a difference between a company’s shares and the company itself. If the stock price drops, people are afraid that the company would go bankrupt. But if the company has cash in the bank account and has no debt, then it won’t go bankrupt.
On the other hand, if the manager embezzles the company, or if the company has illegal activities and loses a lot of money because of that, it could be possible to go bankrupt suddenly. This probability is small but exists.
In this case, you would have limited the disaster if not all of your investing capital would have been placed in a single position. If you would have invested only 5% in that company, you would still 95% of your capital left for better opportunities.
I recommend having 20 to 30 companies in your portfolio.