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I have about one year of experience as an investor and my goal is to aggressively grow my portfolio over the next 40 years for retirement. I have had good success achieving my goal over the last year but as my portfolio grows I'm beginning to feel more cautious. I am especially humbled by major crashes like that of 2009, especially since the major stock indexes are at all-time highs.

Although it is impossible to predict the next stock market crash, what metrics do professional investors such as Warren Buffett use to predict long-term trends and to what accuracy? Ideally I would like to be able to get a better feel for the overall state of the economy so I can adjust my portfolio to match my risk target.

Tom Au
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Nosrac
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2 Answers2

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Although it is impossible to predict the next stock market crash, what are some signs or measures that indicate the economy is unstable?

These questions are really two sides of the same coin. As such, there's really no way to tell, at least not with any amount of accuracy that would allow you time the market.

Instead, follow the advice of William Bernstein regarding long-term investments. I'm paraphrasing, but the gist is:

  • keep a consistent strategy (fund allocation, deposit frequency/amount, etc.) that you adhere to religiously over the years
  • diversify
  • never try to time the market
  • use a dollar-cost averaging (or similar) scheme to take advantage of the peaks and troughs of the market
  • rebalance every 6-12 months
  • keep your head when everyone else is losing his

Markets crash every so often. It's a fact of life. If you maintain financial and investment discipline, you can take advantage of the crashes by having sufficient funds to purchase when stocks are on sale. With a long-term investment horizon, crashes are actually a blessing since you're in prime position to profit from them.

grfrazee
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There are some economic signs as there are in all economic and business cycles, such as interest rates rising. However, a more effective way is to actually look at price action itself.

The definition of an uptrend is higher highs followed by higher lows. The definition of a downtrend is lower lows followed by lower highs.

So if you are looking to invest for the long term you can look at the weekly or even the monthly chart of the market say over the past 10, 15 or 20 years. Using these definitions on say the S&P500 if the price continues to make higher highs and higher lows then stay in the market.

If the price makes a lower high than the previous high, then this is a warning sign that the trend may be about to end. The trend has not broken yet but it is a warning sign that it could be ending soon. If the price makes a higher low next followed by a higher high, then the trend continues and you just need to keep an eye on things.

If, however, the price makes a lower low after the lower high this is a signal that the uptrend is over and you should get out of the market.

If the price makes a lower low directly after a higher high, then be cautious and wait for confirmation that the uptrend is over. If you then get a lower high this is confirmation that the uptrend is over, you would then sell if prices drop below the previous low.

If you invest in individual shares then you should keep an eye on the charts for the index and individual shares as well. The index chart will give you an indication if the uptrend is over for the whole market, then you can be more cautious in regards to the individual shares. You can then plan exit points on each individual share if their trends are broken too. If you have stop losses employed and the trend reverses on the index, this would be a good time to tighten your stop losses on individual shares.

You can then buy back into the market when you determine that the downtrend is broken and prices start to show higher highs and higher lows again.

Will there be occasions when the uptrend reverses and then after a short period starts trending up again, yes there might be, but the worse that will happen is that you pay a bit of extra brokerage to get out and then back into the market, and you might have to pay some capital gains tax on any profits made. But remember no one ever went broke making a profit.

The most important thing to remember when investing is to conserve and protect your capital. I would rather pay some extra brokerage and some capital gains tax than see my portfolio drop by 50% or more, then take 5 years or more to recover. And remember, paying tax is a good thing, it means you made money. If you don't want to pay any tax it means you will never make any profits, because if you make profits you will have to pay tax one day.

Victor
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