Will Your Brokerage Account Be Wiped Out When the Market Crashes?

Ebbs and flows in the market are a way of life. The trick is knowing whether your investments are at risk.

Earlier this week, I had dinner with three women I've known since I was a kid. Somehow, we got on the subject of retirement, which led to a conversation about investments. One of the women reported that her husband wants to pull all of their money out of investment accounts because he's sure the market is about to crash.

Making an informed decision about what's likely to happen to your investments requires information in black and white, uncolored by anxiety or fear. The more accurate information you have at your disposal, the better equipped you are to make rational, balanced decisions. Here is some information to help guide you away from fear and into informed decision-making.

What happens to your brokerage account if the market crashes?

If you have a diversified portfolio, it's possible that some of your investments won't be affected, even as others decline in value. That's why it's so important not to put all your financial eggs in one basket. The more you diversify the sectors you invest in -- and the types of investments you put money into -- the better your chances are of coming out of a crash reasonably unscathed. As some sectors drop, others can hold their own or even make gains.

Let's say you purchased 100 shares of Company A at $20 per share. Your investment is worth $2,000. If the stock price falls to $10 per share, your investment is suddenly worth $1,000. But you haven't really lost anything. You only lose money if you sell at that point. If it appears that Company A is going through a rough patch and will recover, you can make out like a bandit by buying up more shares while the price is low.

Will a crash impact your brokerage account? Probably, but as long as you're invested in solid companies and plan to ride out the natural ups and downs of the market, there's no reason to be afraid.

What if your brokerage firm goes under?

If things get bad and your brokerage firm closes its doors, you have government-provided insurance to help you recover assets. Securities Investor Protection Corporation (SIPC) will cover up to $500,000 of securities or $250,000 of cash held at a brokerage firm.

It's important to know that brokerages expect and plan for downturns in the market. In addition, the U.S. Securities and Exchange Commission's Net Capital Rule makes it mandatory for each brokerage firm to maintain a minimum amount of liquid capital. And the Customer Protection Rule requires them to keep your assets in a separate account from the firm's assets. Finally, all brokers registered under the Securities Exchange Act of 1934 must be a member of the SIPC.

Brokerage failures are exceedingly rare. However, if it does happen, the SIPC will attempt to recover the value of your account at the time of the failure. The SIPC works to recover the number of shares you held. If the investment lost value during the time the brokerage goes under, SIPC will not reimburse any funds lost.

How to know when the stock market is crashing

Ebbs and flows are part of what makes the market work. Think of the last time you flew. Remember the plane dropping a bit before being pushed back up, as though by an invisible hand? The same airflow that makes nervous passengers grip their armrests is what keeps the plane aloft. The market is like that plane, pushed up and down by activity outside your control.

There is no set threshold for a stock market crash. However, when there is an abrupt double-digit percentage drop in a stock market index over a short period, people tend to call it a crash. Quick reminder: The stock market index is a tool that helps investors calculate how well the market is performing by comparing current price levels with past prices.

So, when that stock market index takes a nosedive, investors do one of two things: They panic and sell (causing the market to take a deeper dive), or they calmly buy up newly discounted stock, knowing they'll be money ahead when the market rebounds.

Is a stock market crash inevitable?

The stock market could crash again at some point. If it does, it will join the market crashes of 1929, 1987, 2008, and the so-called "flash crash" of 2010.

While there are more laws in place now to help avoid another crash, it may be best to assume another one will occur anyway. Here's why:

• You can make a plan. Will you grab what you can of your money and hide it if the market crashes, or will you let it ride until the market recovers?
• You can face your fears about losing money. When you're able to remove fear from the equation, you may notice trends or find other options. For example, when prices are low, you may be able to afford to buy more shares.
• You can find new opportunities. The market has always recovered, even after serious crashes. You may think the market will never come back and you'll lose everything, but buying into that idea comes at a cost. If you invest while prices are low, you may find yourself with a fatter portfolio when the recovery comes around.

A savvy investor knows that some years are going to be better than others. Over the 30 years between 1991 and 2020, the annual rate of return of the S&P 500 was 10.7%, according to data from MoneyChimp. When adjusted for inflation, the actual rate of return was 8.3%. When you consider the number of crashes that occurred during those years, it's impressive how well the stock market performed over the long run.

Making money over the long haul is the name of the game. From the moment you open a brokerage account to the day you begin withdrawing funds, it's all about growing your money.