Image source: Getty Image
The words ‘stock market crash’ strike fear into the hearts of many investors. These accidents are not very common. While the market does move down from time to time, a crash is more than just a move down. A common definition of an accident is a loss of value of 20% or more in a short period of time.
I don’t know when the next accident will be. Neither, in fact, anyone. But it has to happen sooner or later.
Instead of striking fear into my heart, that could be great news for me, depending on how I decide to act.
Why an accident could be a great opportunity
What happens in a stock market crash?
The price that buyers are willing to pay and sellers are willing to accept for a stock often falls, sometimes dramatically.
But what about the intrinsic value of that stock? Is it worth much less than it was a few days before?
Sometimes it can be. For example, if a bank run causes the stock market to crash, the bank’s shares could fall. That could reflect investor perceptions (or fears) that after a run against a competitor, a bank will lose some customers and future profitability could suffer. In other words, a lower share price could simply reflect the fact that, in light of events, a reduced company valuation seems realistic.
However, that is not always what happens in a stock market crash. Take a look at the chart below which shows the stock price of Howden CarpentryFor example.
Note the sharp drop in early 2020 when we saw a pandemic related crash.
Did the pandemic affect Howden’s near-term prospects? Absolutely. Profits ended up falling 30% in 2020 compared to the previous year. But did the pandemic change Howden’s long-term outlook enough to see the kind of decline seen in the chart above?
judging odds
We now know that the answer was no. If I had bought Howden shares in the March 2020 stock market crash, I could have more than doubled my money in just a year and a half.
But in a crash you have to make decisions with a vision of the future. In 2020 I did not have the benefit of the retrospective on Howden that I have now.
In practice, that means that as an investor, I try to assess the odds. By sticking to the businesses I understand when considering stocks to add to my portfolio, I feel better able to judge whether they may be affected by certain events. That can help me value them, so that if a stock market crash pushes their price well below that value, I feel reasonably sure I’m looking at a bargain, not a value trap.
getting ready today
That’s why I try to only invest in areas that I understand where I feel I can assess a company’s value and prospects.
My investment philosophy is to try to buy big companies at attractive prices. A crash that pushes stock prices lower, even for companies with largely unchanged prospects, could help me do just that, hopefully accelerating my efforts to build wealth.
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