6 Ways to Prepare for a Market Crash

Every investor lives with the risk, no matter how remote, of a major economic meltdown. It has happened before. It can happen again. If it does, years of hard-earned savings and retirement funds could be wiped out in hours.

Fortunately, there are steps you can take to shield the bulk of your assets from a market crash or even a global economic depression. Preparation and diversification are the key elements of a sound defensive strategy. Together, they can help you weather a financial hurricane.

1. Diversify

Diversifying your portfolio is probably the single most important measure that you can take to shield your investments from a severe bear market.

Depending on your age and your risk tolerance, it may be reasonable for you to have most of your retirement savings in individual stocks, stock mutual funds, or exchange-traded funds (ETFs).

But you need to be prepared to move at least a good portion of that money into something safer if you see a crisis looming.

Individuals these days can put their money in a wide range of investments, each with its own level of risk: stocks, bonds, cash, real estate, derivatives, cash value life insurance, annuities, and precious metals are a few of them. You can even dabble in alternative holdings, perhaps with a small interest in a producing oil and gas project.

Spreading your wealth across several of these categories is the best way to ensure that you have something left if the bottom really falls out.

2. Fly to Safety

Whenever there is real turbulence in the markets, most professional traders move to cash or cash equivalents. You may want to do the same if you can do it before the crash comes.

If you get out quickly, you can get back in when prices are much lower. Then, when the trend eventually reverses, you can profit that much more from the appreciation.

3. Get a Guarantee

You probably don't want all of your savings in guaranteed investments. They just don't pay off well enough. But it's wise to keep at least a small portion in something that isn’t going to fall with the markets.

If you are a short-term investor, bank CDs and Treasury securities are a good bet.

If you are investing for a longer time period, fixed or indexed annuities or even indexed universal life insurance products can provide better returns than Treasury bonds. Corporate bonds and even the preferred stocks of blue-chip companies can also provide competitive income with minimal to moderate risk.

4. Hedge Your Bets 

If you see a major downturn ahead, don’t hesitate to set yourself up to profit directly from it. There are several ways you can do this, and the best way for you will depend on your risk tolerance and your time horizon.

If you own shares of stock that you think are going to fall, then you could sell the stock short and buy it back when the chart patterns show that it's probably near the bottom.

This is easier to do when you already own the stock you’re going to short. That way, if the market moves against you, you can simply deliver your shares to the broker and pay the difference in price in cash.

Another alternative is to buy put options on any stocks that you own that have options or on one or more of the financial indices. These derivatives will increase enormously in value if the price of the underlying security or benchmark drops in value.

5. Pay Off Debts

If you have substantial debts, you may be better off liquidating some or all of your holdings and paying off the debts if you see bad weather approaching in the markets. This is especially smart if you have a lot of high-interest debt such as credit card balances or other consumer loans. At least you'll be left with a relatively stable balance sheet while the bear market roars.

Paying off your house or at least a good chunk of your mortgage also can be a good idea. Minimizing your monthly obligations is never a bad idea.

6. Find the Silver Tax Lining

If you are not able to directly shield your investments from a collapse there are still ways you can take the sting out of your losses.

Tax-loss harvesting is one option for losses sustained in taxable accounts. You simply sell all of your losing positions and buy them back at least 31 days later. (That means selling before the end of the current tax year to realize the loss before Jan. 1, and then buying the stocks back, if you so choose, in 31 days or later.). Repurchasing the stocks prior to this time would be deemed a "wash sale" by the IRS, and the ability to claim the loss would be disallowed.)

Then you can write all of your losses off against any gains that you have realized in those accounts. You can carry forward any excess losses to a future year and also write off up to $3,000 of losses each year against your ordinary income.

Consider Converting to a Roth Account

If you own any traditional IRAs or other qualified retirement plans from former employers that you can move, consider converting some or all of them into Roth IRAs while their values are depressed. This will effectively reduce the amount of the conversion, and thus the taxable income that you must declare.

For example, a 30% drop in the value of a $90,000 IRA means $27,000 less that you will not have to pay taxes on if you convert the entire balance in one year.

This strategy is a particularly good idea if you happen to be unemployed for part or all of the year, because you may be in one of the lower tax brackets even with the conversion.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal. Investors should consider engaging a financial professional to determine a suitable retirement savings, tax, and investment strategy.