If a Stock Market Crash Is Coming, History Says You'll Survive If You Make This Move (Hint: It Does Not Mean Going to Cash)

When your stock portfolio starts working, which has happened to many over the last few years, some investors begin to question whether a crash is near. You can't go broke taking a profit and moving to cash. At least, that's how the old saying goes.

What if the adage is completely misguided? If a crash is coming, the worst thing you can do is sell your stocks and hold cash. You'll be better prepared to survive through the gyrations of the stock market if you make this move instead.

Diversifying with fixed income

Going to cash -- especially with a huge portion of your portfolio -- can be very risky, even when the bull market looks extreme. Cash does not go up in value, and even if you park it in a money market fund, it will pay less in annual interest payments than long-term bonds. Plus, if you sell a huge chunk of your winning stocks, you will be required to pay taxes on capital gains.

If you are worried about a market crash, it is better to buy long-term bonds rather than go to cash. Bonds pay higher annual interest (the 30-year U.S. Treasury bond currently yields 5.25%) and tend to rise during market downturns. Why? Market downturns generally occur when the economy contracts, prompting central bankers to try to stimulate economic activity. One of their core tools for doing so is lowering interest rates. When bond interest rates fall, bond prices rise, so bonds tend to perform well during bear markets, at least most of the time.

The number of bonds you own in your portfolio should depend on your own personal situation. Younger people with many years of saving ahead can own a minimal number, while retirees may even want bonds to make up a higher portion of their portfolios than stocks do.

How does an individual buy bonds? The easiest way is through exchange-traded funds (ETFs), such as the iShares 20+ Year Treasury Bond ETF (NASDAQ: TLT). This allows you to easily buy and sell a portfolio of long-term bonds just as you would a stock in your brokerage account.

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Staying uncorrelated with your portfolio

Owning bonds may seem unproductive in a bull market, but their non-correlation with stocks makes them valuable in a portfolio. Cash can give you the freedom to buy stocks at any time in the future, but it has zero upside and pays minimal interest.

If someone has 100% of their portfolio in AI winners, the last few years have likely led to major outperformance. But as astute market historians know, when hot thematic stocks lose momentum, it can mean sharp drawdowns. In 2022 and 2001, hot technology stocks fell by 80% or more in the fallout from their respective bubbles.

Anyone looking to buy stocks in a bear market will have a tough time selling these massive losers to fund new purchases. Fixed income, such as long-term bonds, can serve as a useful counterweight that may appreciate in value during a bear market, allowing investors to rebalance and mitigate the financial and psychological effects of downturns.

Again, an individual should not dramatically shift their portfolio to bonds if they believe a bull market is ending. Stocks perform better over the long term. Investors who are heavily concentrated in technology, artificial intelligence, or other popular names of the day might want to think about mixing in some fixed income to create a portfolio of uncorrelated returns.

Is a crash coming?

Trying to time a market crash is foolish, but one will eventually arrive. Since 1900, the U.S. stock market has fallen by 20% or more 33 times, meaning you can bet that one or two bear markets will occur each decade.

Whether that will be this month or five years from now, I couldn't tell you. Predicting exactly when a market crash will arrive is extremely difficult, but preparing a portfolio to swim through to the other side by owning assets like bonds is straightforward for any investor.

Brett Schafer has positions in iShares Trust-iShares 20+ Year Treasury Bond ETF. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.