The boreal forest of North America and Russia is considered the largest alpine forest in the world. Besides its immense size, this forest has something truly unique about it. Every so often, it's ravished by an inferno of forest fires. While this sounds bad, it's both natural and beneficial. The fires purge the woodland of all the excess shrubs and ground cover so new trees can grow.
You're probably wondering what this random nature factoid has to do with the stock market. Just like the boreal forest, the stock market needs occasional purging. Instead of weeds and shrubbery, it becomes overrun with rampant speculation and an overall lack of fundamental analysis.
The "fire" is a market crash, not unlike what we are going through right now, and it's 100% necessary for a future healthy stock market.
It's very painful, especially for the "shrubs" and the "weeds," but there are groups of investors who will emerge as winners.
1. Investors with long-term time horizons
The biggest advantage you can give yourself as an investor is time. This is why it's so important to start investing as early as possible.
While it's impossible to say when a crash will recover, the market has a perfect record in that department. Every single crash so far has not only recovered to all-time highs but also surged much higher.
On average, stocks decline about 36% in a bear market but rise nearly three times that in a bull market. And bull markets last substantially longer as well.
If you're a young investor with decades of time before retirement, there is little to worry about. Market crashes become less and less significant the longer you stay invested.
Image source: Getty Images.
2. Net buyers of stocks
While most of the "experts" are trying to call the bottom, smart investors are loading up on the best companies in the U.S. at extreme discounts.
Simply look at past crashes to see the benefits of being a net buyer. In the Great Financial Crisis (GFC), the S&P 500 (SNPINDEX: ^GSPC) shed about 55% from peak to trough. Even worse, it took over five years to get back to that peak.
Ouch.
But it's a huge flaw in logic to decide to wait until that happens to get back into the market.
The recovery following a crash is one of the best times to be an investor. From the bottom of the GFC to the eventual recovery in 2013, the market returned over 100%. As a regular buyer of stocks, you wouldn't have timed the bottom (nor should you try), but you would have bought at or near the bottom.
3. Those who did their research
Panic-selling is often a byproduct of little to no due diligence. If you buy a stock at the recommendation of a friend or simply because a smart-sounding TV analyst likes it, you will not have the conviction to hold onto your shares in a crash.
Your due diligence and research are what you fall back on when the going get's tough. It's the only way for you to know if the market is overreacting or if the business is truly in trouble.
The winners of crashes are those who avoid panic-selling great companies, and the best way to do that is by having a well-researched thesis for each of your holdings.
The losers of market crashes
1. Hype-chasers
The months or years leading up to a crash are fueled by greed and fear of missing out (FOMO). You'll see people who have never invested in stocks suddenly bragging about huge gains. The hype-chasers seem to be winning.
But they almost never do.
Long-term returns are driven by company earnings. While it's possible for speculation to drive the prices up in the short term, eventually, the stock price always returns to its anchor: profits.
And unfortunately, when that happens, hype-chasers and speculators almost always get wiped out.
2. Margin users
Margin is borrowing money from your brokerage to increase your purchasing power. There is a strong correlation between increasing margin usage and subsequent market crashes.
As speculators become greedier, they elect to take on margin to try and maximize their returns. The problem is that by taking on debt, they forfeit free will in the case of a correction in prices.
If the prices of stocks drop too far, their brokerage company will force them to liquidate their holdings to cover the cost of the debt.
If that sounds scary, it's because it is.
Extreme margin users nearly always get liquidated during a crash, and for many of them, it's so painful they never return to the market.
Winning comes down to mindset
Mindset is everything in a crash. Once you understand that crashes are both healthy occurrences for the market and massive opportunities for emotionally strong investors, you're well on your way to becoming a winner in this downturn.
