You must plan for a stock market collapse if you want to avoid a crash.

But, no one can predict the future. It can be difficult to predict the future of the stock market.
However, this doesn't mean that you are out of options if your goal is to be prepared for the next stock market storm. Understanding your risks is one of the best ways for long-term success.

Let's see what you can do for your portfolio in the event of a stock market crash.

There is no way to predict when a market correction will occur. However, investors might believe that a pullback is possible based on their technical research.

There are several things you can look for to determine if the economy or market is heading towards upside extremes. Here are some signs to watch out for.

P/E Ratios

The historical P/E (price-to-earnings) valuations of the S&P 500 index ranged in the 15-16X region. The S&P 500's P/E ratio has risen to nearly 21X as of December 2021.

This is definitely an overvalued market in historical terms. The market has been overvalued since a long time. You would not have gotten the greatest gains if you tried to create a crash-proof portfolio one year ago.

Economy

Consumers will cut back on spending if there are high unemployment rates or lower wages. Companies that trade on the stock exchange will see lower earnings.

Share price can be affected by company earnings. Lower earnings can lead to lower prices. This is how an economic recession could eventually lead to a stock market crash.

Leading Economic Index (LEI).

The Conference Board Leading Economic Index is a great tool to track the state of the economy. It includes 10 components that help identify peak and bottom points in the business cycle. Investors can use the LEI to predict the economic performance over the next few quarters.

FED Policy

Modern markets are being controlled by central banks all over the globe. The market will continue to rise if the FED continues to pump money into the market each month as it does now. The FED not increasing interest rates and adding money to the markets can have a negative impact on the performance of the economy and market performance.

The problems with trying to time the market

You may feel tempted to change your portfolio's risk-on to risk-off if you think there will be a stock market collapse. This usually involves reducing equity positions, increasing cash and possibly increasing bond holdings. This could include even adding gold.

The problem with the stock market is that it can appear to be about to crash for many years before it actually does. The market keeps rising even though you have positioned your portfolio to take a pullback. You miss out on many gains.

Worse, if your portfolio is reoriented for a crash, and you decide to buy put options to hedge against the crash, you could end up with negative returns. We don't recommend trying to predict the market for long-term investors.

How to plan your portfolio for a stock market crash

If market timing is not the answer, then how can one prepare their portfolio to a stock-market crash? These are the three steps you can take in order to make sure you don't get caught flat-footed.

Verify Your Asset Allocation

Asset allocation is the ratio of stocks and bonds in your portfolio. This is what most financial professionals refer to when discussing asset allocation. Your portfolio's weighting towards stocks is more aggressive. Bond-heavy portfolios are conservative.

You may have chosen a target asset allocation that is appropriate for your risk tolerance when you set up your portfolio, whether you use a robo-advisor or on your own. Your portfolio can drift away from its target asset allocation over time due to outperformance of your bond investments.

These changes are often overlooked when the market is making gains. These shifts can increase your losses in market corrections. Let's take, for instance, that your target allocation is 70% stocks, 30% bonds. Your portfolio's peak and troughs should be less than one that is composed of 95% stocks, 5% bonds, and vice versa.

Let's suppose that your allocation has been steadily shifting away from your target over several years. It is now 85% stocks and 15% bond. Your portfolio will likely suffer a more severe decline in the event of a stock market crash, although it is less dramatic than an investor whose portfolio has a 95/5 ratio stocks-to-bonds.

You should make sure your asset allocation matches your target if you are worried about a stock market crash. You should rebalance your portfolio if it isn't. You can find out how to do it here >>

Think about your investment outlook

A "investment horizon" refers to the time period that investments can grow before the investor has to sell them. How you prepare for a stock market crash should be influenced by your investing horizon.

If you are investing primarily for retirement and don't intend to retire in the next 20 years, then you should consider the "do nothing” strategy. Keep investing and don't sell your securities.

A stock market crash can be disastrous if you plan to retire within two years. You may need to withdraw funds as soon as the market has not recovered.

It doesn't matter if you believe a stock market correction will occur, but it is a smart idea to shift your asset allocation toward a more conservative mix towards the time you are about to withdraw. This can be done by you or you could use a Target Date Fund to do it automatically.

Do not be afraid to seek professional help

A financial planner can help you create a plan and give you peace of mind if you are worried about a stock market crash. Expert advisors should monitor the market for excessive trading and be able to determine when to reduce equity holdings.

These decreases in equity prices won't be as drastic as what you might expect from a novice investor trying to time the market. They are only intended to reduce the potential impact of a market correction. Investors will likely see lower returns if the market crashes.

An advisor might reassure you about your investment strategy, but not recommend any defensive measures. If an advisor does make allocation recommendations, they will do so with the intent of still being in a position to benefit from gains if the market rises.

A robo-advisor may be a good option to move your investments to. Robo-advisors will help you create a portfolio that meets your risk tolerance and investment goals. They'll also automatically rebalance and rebalance your assets over time. They generally have lower management fees than human advisors. Our top picks for robo-advisors.

Last Thoughts

There are many ways you can monitor the market and economy for signs of a possible correction. Newsletters that combine economic and market data can be very helpful. You can also perform your own technical analysis with common indicators such as P/E ratios.

Optimizing your asset allocation will help you prepare for a stock market crash. As mentioned, a financial planner, or robo-advisor, can help you create a portfolio that is the best fit for your goals and needs.