The Best Way to Deal with a Stock Market Crash

I may be biased but I think Benjamin Graham doesn't get the credit he deserves. Especially from new age investors.

They seem to take a very shallow approach to his works and writings. It's fair to say they miss the forest for the trees. Their sole focus is on his formulae and techniques. What need to be studied are his principles and tenets.

Warren Buffett was right when he said that certain things will never go obsolete in investing.

These are ideas like stocks represent a part ownership of businesses or that their prices keep fluctuating because of the human tendency to give in to emotions of greed and fear.

And last but not least, the extremely important concept of margin of safety.

These are all timeless ideas. They will be as valid and useful 100 years from now as they are today. They have all come from the brilliant mind of none other than Benjamin Graham.

I've written a lot about Graham and his timeless principles. In fact, I have run out of new things or new insights to say about the father of value investing.

But not today. You see, Jason Zweig, a financial write of repute, has transcribed one of Graham's lesser known speeches that he gave back in 1963.

So impressed was Zweig with the speech, he immediately called it a 'Rediscovered Masterpiece'.

When Zweig sent the speech to Warren Buffett, it led to a similar response from the Oracle of Omaha. Buffett regarded it as one of the best of Graham's speeches.

I first read the speech about 3 years ago. And have read it cover-to-cover many times since. In fact, whenever I'm confused about what to do next in the stock market, I go back to this speech. It has often helped me see the light.

I think we are going through a similar period of uncertainty and confusion right now. There's war, there's the looming threat of inflation, and there's constant barrage of opinions on social media.

Hence, what better time than now to pick the brains of one of the smartest investors ever through one of his best speeches.

Graham admits right at the beginning, of the three threats that exist in the field of financial security, he has nothing to offer on two of them.

The first one being the threat to our financial security because of an atomic war. Quite obviously, Graham has nothing to say here. In fact, no one can possibly have anything to say here.

The second threat is the threat of inflation. Again, Graham has no clear prescription here. Although he does mention that inflation will stay with us and stocks offer a good defense against it.

The third and final threat is where he really gets into his elements. This is the threat to financial security from big stock market corrections. Graham tries to answer the all-important question about how to deal with market crashes.

Let me try and explain this using the Indian stock market as an example.

It's October 2021 and the Sensex has made a new all-time high of 61,766. According to Graham, there were three ways of reacting to this landmark achievement.

There was a group of smart investors out there, grinning from ear to ear. They think markets will keep going up and the declines, if any, are not that important. So if you have a true investor's attitude, you don't have to worry too much about declines.

Then there was another smart group for whom it was all about the underlying businesses. That the stock market was reaching one new high after another was of no consequence to them. They were of the view that as long as they have good quality stocks in the portfolio, they will keep going up.

Well, the third and the final group always approached the markets with caution.

Having studied stock market history, they were clear that investors cannot have a dependable view on the market's future action in the next year or so. But a large and disturbing decline is likely to take place again sometime in the future.

Hence, they should be prepared in thought and action for it.

If Graham is to be believed, it's the approach of the third group that one should try to adopt in the stock market.

The approaches of the first two groups are fraught with risks. To think that the declines are unimportant is like playing with fire. It leads an investor down the wrong path.

Imagine someone putting a substantial portion of his net worth into stocks back in October 2021. The fact that the markets had risen phenomenally since then would have given him confidence that they would continue to do so in the future as well.

However, as Graham says, a large advance in the stock market is basically a sign for caution and not a reason for confidence. Had he exercised caution and invested only a small percentage; he wouldn't have been sitting on such a huge loss as he is right now.

What about the second group for whom only the business quality matters? Well, Graham argues that there is no evidence that good quality businesses go up during a deep market crash. Like other stocks, they also correct and often as deeply as the broader market.

Besides, if one is invested all the time, it becomes very difficult to outperform the benchmark index even if you think you have good quality stocks in your portfolio.

Therefore, if your goal is to outperform the benchmark index over the long term and also to protect your portfolio against a big stock market crash, you need to keep toggling between stocks and bonds based on the broader stock market valuations.

If you want to avoid the pain of a huge stock market crash, you cannot expect to avoid it more successfully than others unless you think independently from the crowd.

Let us summarise the key takeaway in his own words,

• The investor must recognize that there are uncertain and hence speculative elements in any policy he follows - even an all-government-bond program.
  
  He must deal with these uncertainties by a policy of continuous compromise between bonds and common stocks, and by adequate diversification.
  
  He must make a strong effort to have more money invested in common stocks at lower market levels (at least on the basis of cost) than at what he recognizes to be potentially high levels.

Thus, in investing, you have two choices.

Either you stay fully invested and keep worrying about things like Russia-Ukraine conflict, runaway inflation, crude oil prices etc or you follow the Graham approach.

Here you move between stocks and bonds such that you take some money out of stocks once they start looking expensive and put money back once they turn cheap.

The choice is yours!

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter