First let’s define “Crash”. To most, the term implies a decline of severe magnitude. A key question is the duration of the impairment, or how long might it take to recover? Another consideration is stock market valuation.
By my observation, there hasn’t been a stock market crash in the US in the last hundred years that began with stocks at historically reasonable valuations that persisted more than 5 years. The risk of a crash depends on valuation. The average PE ratio in 1929 was about 60 times earnings. Fifteen or sixteen is widely considered average, and implies a 6.25% to 6.67% earnings yield. That’s reasonable. Today, the PE for the S&P 500 is was 18.94 on 9/26/2014 according to the Wall Street Journal, and that’s a little above normal. It implies expectations that the economy and growth will continue to accelerate from the anemic post mortgage crisis recovery.
So how do you prepare, just in case? The conventional approach to hedging the stock market is to incorporate bonds to a portfolio. You own bonds for either of two reasons; either you need income, or you want to reduce the volatility of a portfolio. Currently the ability of bonds to generate income is diminished by Fed policy. While bonds may still provide some stability in the event of a crash, it is widely recognized that interest rates are likely to rise and that will reduce the value of outstanding bonds with fixed coupons. Choose your poison.
An alternative strategy is to focus on the likely duration of a downturn in the stock market, and plan for expected liquidity needs for that amount of time. A key benefit of financial planning is that it identifies liquidity needs. During a period of low interest rates, one can substitute a reserve strategy, often called the Bucket Approach, to provide for anticipated liquidity needs for as long as a crash/correction might be likely to persist. This frees the remainder of the portfolio for management with a longer time horizon, and with focus of fundamental metrics like valuation and macroeconomic factors.