Stock Market Corrections

Stock Market Corrections (How to Profit in Both Boom and Bust Markets)

The Rich Dad five-point plan to profit during any market correction

According to the VIX index —which is known as the “Fear Gauge”—we’re coming off one of the biggest spikes of fear and uncertainty in years. Not surprising given the fact that we just experienced a global pandemic.

VIX index

Not surprisingly, the fear index spike in early 2020 coincided with a massive drop in the stock market. You can see that reflected in the Dow Jones chart below.

Dow

One thing you can know for certain is that in the dips and the spikes, a lot of money was lost...and a lot of money was made. The difference was those with financial intelligence and those who follow the herd.

A stock market correction is coming

In 2017, this “Fear Gauge” was at its lowest since 1993.

And professional traders were scared out of their mind.

Allison Schrader, writing for Quartz, interviewed some professional traders at the time on the “good” news of the low VIX index. Here’s what she wrote:

I recently asked a few traders if they believed lower volatility reflected less risk in the markets. They laughed nervously and said, in essence, “a correction is coming and it will be ugly.” They expect a big group, eventually, will get nervous enough and pull out of the market—maybe institutional investors (pension funds, foundations, and the like) or recent retirees. Once this starts, more will follow. Then, one trader says, it will be “carnage.”
The VIX index is supposed to be a measure of expected volatility in the markets. That it was so low was an indication that most investors were expecting calmness, and yet, traders were scared out of their minds. I don’t think they’re feeling much better today.
The truth is that many professional investors are enjoying the gains in the market, but they’re also waiting for the other shoe to drop. It always does, and those who get hurt most are the amateurs.

The world is in uncharted territory

A few years ago, I wrote this on the morning after the Brexit vote:

This morning, I woke up to find the citizens of Britain voted, by a count of 52% to 48%, to exit the European Union (EU). England is the most financially and politically important member in the EU and the first country ever to leave the EU.

Welcome to an uncharted future.

The weeks leading up to the vote had most analysts guessing wrong about which way the vote would go. Along with voting to leave the EU, the vote also meant England will be getting a new prime minister, since David Cameron resigned in the wake of the vote.

In my opinion, the only known fact is that this will create an increase in volatility.

Since then, things have gotten more volatile, not less. We’ve had continual dust ups with North Korea. There’s been political unrest at home, and that’s probably not going away any time soon. And a global cyberattack shut down a major pipeline in the US. And an aggressive strain of COVID is coming out of India.

Indeed, we are continuing our journey into the uncharted future.

The problem with predictions

In my article on Brexit, I also talked about how difficult it was to predict the future.

Predicting the future is a loser’s game. It’s easy to be wrong and nearly impossible to be completely right…the hard part about predicting the future is actually following through on the actions that agree with your predictions. There are always more naysayers than believers.

I talked about the Biblical story of Noah. He spent years and years of his life building an ark in the middle of the desert, all the while talking about a coming flood. Everyone mocked him…until the flood came. Then they all wanted on the ark, but it was too late.

In my book, Rich Dad’s Prophecy, I predicted that the biggest stock market crash in world history would happen sometime around 2016. Case in point, it is difficult to predict the future. It’s 2021 and the BIG crash hasn’t happened yet. Many people are happy to point fingers and say, “I told you so.” But I believe the correction will still happen—and like Noah I’m still preparing.

Is the big stock market crash (and correction) still coming?

The 75 million baby boomers hold about $10 trillion in tax-deferred savings that they are required to withdraw, and they will do so increasingly in the coming years.

In an interview with MarketWatch, I said:

“I’m not concerned about the professional investor who can short the market, go long, use options, calls and puts,” he said. “It’s the person with a 401(k) or IRA, where all their eggs are in this thing called a retirement plan.”

The professional investors on Wall Street are scared. Things are good in the markets...almost too good. They know that a correction is coming. And when it does, the little guys will be wiped out.

Whether there is a correction this year or in the coming years, one thing is true, corrections always come. The good news is there is always opportunity in every boom and bust—if you prepare well.

The markets always booms and busts...but will you profit?

One key to preparing is to understand the nature of market booms and busts. This can be done by understanding history and then seeing the patterns of history in play in our world today.

Over the years, I have read several books on the subject of booms and busts. Almost all of them cover the Tulip Mania in Holland, the South Seas Bubble, and, of course, the Great Depression. One of the better books—“Can It Happen Again?”—was written in 1982 by Nobel Laureate Hyman Minsky.

In this book, he described the seven stages of a financial bubble. They are:

  1. Stage 1: A financial shock wave

    A crisis begins when a financial disturbance alters the current economic status quo. It could be a war, low interest rates, or new technology, as was the case in the dot-com boom.

  2. Stage 2: Acceleration

    Not all financial shocks turn into booms. What’s required is fuel to get the fire going. After 9/11, I believe the fuel in the real estate market was a panic as the stock market crashed and interest rates fell. Billions of dollars flooded into the system from banks and the stock market, and the biggest real estate boom in history took place.

  3. Stage 3: Euphoria

    We have all missed booms. A wise investor knows to wait for the next boom, rather than jump in if they’ve missed the current one. But when acceleration turns to euphoria, the greater fools rush in.

    By 2003, every fool was getting into real estate. The checkout girl at my local supermarket handed me her newly printed real estate agent business card. The housing market became the hot topic for discussion at parties. “Flipping” became the buzzword at PTA meetings. Homes became ATM machines as credit-card debtors took long-term loans to pay off short-term debt.

    Mortgage companies advertised repeatedly, wooing people to borrow more money. Financial planners, tired of explaining to their clients why their retirement plans had lost money, jumped ship to become mortgage brokers. During this euphoric period, amateurs believed they were real estate geniuses. They would tell anyone who would listen about how much money they had made and how smart they were.

  4. Stage 4: Financial distress

    Insiders sell to outsiders. The greater fools are now streaming into the trap. The last fools are the ones who stood on the sidelines for years, watching the prices go up, terrified of jumping in. Finally, the euphoria and stories of friends and neighbors making a killing in the market gets to them. The latecomers, skeptics, amateurs, and the timid are finally overcome by greed and rush into the trap, cash in hand.

    It’s not long before reality and distress sets in. The greater fools realize that they’re in trouble. Terror sets in, and they begin to sell. They begin to hate the asset they once loved, regardless of whether it’s a stock, bond, mutual fund, real estate, or precious metals.

  5. Stage 5: The market reverses, and the boom turns into a bust

    The amateurs begin to realize that prices don’t always go up. They may notice that the professionals have sold and are no longer buying. Buyers turn into sellers, and prices begin to drop, causing banks to tighten up.

    Minsky refers to this period as “discredit.” My rich dad said, “This is when God reminds you that you’re not as smart as you thought you were.” The easy money is gone, and losses start to accelerate. In real estate, the greater fool realizes he owes more on his property than it's worth. He's upside down financially.

  6. Stage 6: The panic begins

    Amateurs now hate their assets. They start to dump it as prices fall and banks stop lending. The panic accelerates. The boom is now officially a bust. At this time, controls might be installed to slow the fall, as is often the case with the stock market. If the tumble continues, people begin looking for a lender of last resort to save us all. Often, this is the central bank.

    The good news is that at this stage, the professional investors wake up from their slumber and get excited again. They’re like a hibernating bear waking after a long sleep and finding a row of garbage cans, filled with expensive food and champagne from the party the night before, positioned right outside their den.

  7. Stage 7: The White Knight rides in

    Occasionally, the bust really explodes, and the government must step in—as it did after the 2008 crash, buying shares in companies like GM and bailing out large Wall Street banks that leveraged themselves too far.

Today, you should ask yourself what stage you think we’re in. The stock market is at an all time high. Investors are running to IPOs like Snapchat even though the company is losing money twice as fast as it did prior to its IPO. The VIX index is going down while the world is getting more volatile.

And professional traders are saying, “a correction is coming and it will be ugly.”

I can’t tell you what will happen exactly, but I can tell you that you better be prepared. The good news is I have a five-point plan to share with you on how to be profitable in any market.

The Rich Dad five-point plan to profit during stock market corrections

The first step to success in any market is obvious enough, but too often ignored. Know what your money is invested in!

If you don’t plan on investing in financial education, then by all means, keep your money in your 401(k) and let it sit there. It’s safer than moving money without the knowledge of how or why. But if you want to be prepared to make money in any market, you need to understand how to make that money work for you.

A great place to start is by reading Andy Tanner’s Blog and the Rich Dad Blog.

  1. Know your position

    The sad reality is that most people don’t even know what their retirement money is invested in. The money gets pulled out of a check, goes to a magical place called a managed investment account, and is moved around by a wizard called a financial manager.

  2. Know how you’ll perform

    Once you understand what your money is invested in, you need to understand how those investments will perform in a given market. For instance, if interest rates are hiked substantially, as the Fed seems to be prepping for, there’s a good chance that stocks and bonds will fall—and these make up most investors’ retirement accounts.

    Therefore, in such a market, it may be time to invest in real estate before interest rates go higher.

  3. Get educated

    This means that you can’t just take advice about the market, you have to educate yourself so you can see what’s coming and have time to prepare.

  4. Slowly pare back your risk

    With the proper education, you can see better where the markets are going, how your current asset mix will perform in the coming markets, and how much risk you have. This allows you to make the proper adjustments to minimize your risk and take positions that will perform well whether the market is going up or down. And it leads us to the final point.

  5. Buy in pairs

    Professional investors always buy in pairs. One position is for growth, and the other is for protection. So for instance, if you’re heavily invested in the stock market and paper assets, you want to take an insurance stake in precious metals or commodities. If you buy real estate, you want to also buy insurance for that real estate.

The list can go on and on. This of course takes financial education, but the investment is worth it.

Original publish date: May 17, 2017