Week 31 Day 4: What to Actually Do During a Crash

When the market crashes 30%, your action plan: Do nothing with your existing investments. Keep your automatic monthly investments running (you are buying shares on sale). If you have extra cash in savings (beyond your emergency fund), consider investing some of it. Turn off financial news and check your portfolio no more than once per month.

The crash response checklist in detail: (1) Verify your emergency fund is intact (3-6 months of expenses in high-yield savings). If yes, you can weather a job loss without touching investments. (2) Confirm automatic investments are still running. Call your brokerage if needed. (3) Check your asset allocation. If your target is 70/30 stocks/bonds and stocks have crashed to make it 55/45, rebalance by selling bonds and buying stocks. This forces 'buy low' behavior. (4) Consider tax-loss harvesting in taxable accounts: sell losing positions to realize a tax loss, immediately buy a similar (but not identical) fund to maintain exposure. Example: sell VTI at a loss, buy SCHB (both track the total U.S. market). The tax loss offsets capital gains or up to $3,000 of ordinary income per year. (5) Increase contributions if possible. During the 2020 COVID crash, investors who increased their 401(k) contributions by even 1-2% captured significant additional upside on the recovery. (6) Review your investment policy statement (the written plan you created during Week 29). Confirm your pre-committed response to drawdowns. (7) Talk to a trusted friend or financial advisor if you feel the urge to sell. Having someone talk you off the ledge during a panic is worth its weight in gold.

The optimal response to market crashes for a long-term investor is formally derived from Merton's (1971) intertemporal CAPM: the optimal equity allocation is a function of risk tolerance, the equity premium, and variance. During crashes, the equity premium (measured by the forward-looking earnings yield or the CAPE yield vs bond yield) increases while realized volatility is high but mean-reverting. For a constant risk tolerance investor, the optimal response is to increase equity allocation as prices fall (and expected returns rise). This is the rebalancing effect: buying cheap stocks funded by selling expensive bonds. Perold and Sharpe (1988) showed that constant-mix rebalancing (maintaining fixed asset allocation weights) is a concave strategy that profits from mean reversion: if prices fall and then recover, the rebalancing investor ends up richer than a buy-and-hold investor because they bought additional shares at lower prices. The expected value of rebalancing is approximately 0.3-0.5% per year for a 60/40 portfolio with annual rebalancing (Willenbrock, 2011). During severe crashes (when the rebalancing trades are largest), the contribution can be significantly higher. The tax-loss harvesting opportunity during crashes is also valuable: Berkin and Ye (2003) estimated the annual tax alpha of systematic tax-loss harvesting at approximately 0.7-1.0% for taxable accounts -- and this alpha is concentrated during drawdowns when losses are plentiful.