A bear market refers to a decline in stock prices of at least 15-20%, coupled with pessimistic sentiment underlying the market. Clearly no stock investor looks forward to these periods. Don't despair, there is hope! In this article we will walk you through some of the most important investment strategies and mindsets that one can use to limit losses - or even make gains - while the stock market is performing in such a manner.
First off, having a realistic mindset is one the most important things to do during an economic slowdown. Remember that it's normal for the stock market to have negative years - it's all part of the business cycle.
After a raging bull market, it's easy to forget the bad times. Take, for example, the late 1990s; it was a time of spectacular growth in the equity markets, punctuated by gains in the S&P 500 of 33.4%, 28.6% and 21.0% in 1997, 1998 and 1999 respectively. Historically, the market has grown around 8-10% per year (depending on whose numbers you use). To expect the market to grow at a 20%+ rate forever goes against everything we can learn from history. Occasional slowdowns are inevitable.
If you are a long-term investor (meaning a time horizon of 10+ years), one option is to just ignore the market and go on with business as usual. By this we mean investing in a regular, mechanical fashion known as dollar-cost averaging. By purchasing shares regardless of price, you end up buying shares at a cheap price when the market is down. Over the long run your cost will "average down" and you'll be better of in the end - at least that's the theory.
Where to Invest in Bear Country
There are a number of things you can do to protect yourself from bears - and maybe even eke out some gains. Let's take a look:
- Play Dead - Stay on the Sidelines
During a bear market, the bears rule and bulls don\'t stand a chance. There\'s an old saying that the best thing to do during a bear market is to play dead - it\'s the same protocol as if you meet a real grizzly in the woods. Fighting back would be very dangerous. By staying calm and not making any sudden moves, you\'ll save yourself from becoming a bear\'s lunch.
Playing dead in financial terms means putting a larger portion of your portfolio on the sidelines in the form of money market securities. In a bull market, it is detrimental to have uninvested cash around because it isn\'t working to get the best potential return. This isn\'t true in a bear market because cash will hold its value (and earn at least some interest) when stocks head south. When the right buying opportunity comes along, you\'ll have the flexibility to go for it. Of course, this means you have to be timing the market to some extent, a task that is tough, if not impossible, to do precisely. However, the point is that during a bear market, even if you take some cash out of the market later rather than sooner, this may still prove to be a good decision if the bears rule for a sustained period.
- Value Stocks
Bear markets can provide great opportunities for investors. The trick is to know what you are looking for. Beaten up, battered, underpriced: these are all descriptions of stocks during a bear market. Value investors often view a bear market as a buying opportunity because the valuations of good companies get hammered down along with the poor companies and sit at very attractive valuations. However, value investing is an art; not every stock in a bear market is a bargain, but this is a time when some real bargains can definitely arise. Take Warren Buffett, for example. He often builds up his position in some of his favorite stocks during less than cheery times in the market because he knows that the market\'s manic-depressive nature can punish even good companies more than warranted. (To learn more about the art of value investing check out our Guide To Stock Picking Strategies.)
- Short Selling
Another approach to a bear market is to adopt a more aggressive strategy. A short position allows an investor to profit as the stock heads downward. Keep in mind that the ability to profit on the other side of a stock is accompanied by substantial risks, mainly the fact that, in theory, you could lose a lot more that 100% of your initial investment by taking a short position in a company. (To learn more about short selling check out our Short Selling Tutorial.)
- Bonds and Asset Allocation
Asset allocation proves itself during times of stock market underperformance. During economic boom times, investors are kicking themselves for not being all in equities. The exact opposite is true during times of economic hardship and stock market downturns. Having a percentage of your portfolio spread among stocks, bonds, cash and alternative assets is the core of diversification. How you slice up your portfolio depends on your risk tolerance, time horizon, goals, etc. Every investor\'s situation is different. (For more on this subject see the following article: Portfolio Protection In Diversification And Discipline.)
- Defensive Industries
There are equity securities that generally perform better than the overall market during bad times. These industries have become known as defensive industries, or non-cyclical industries, because they refer to the defense they provide your portfolio in times when the stock market plummets. Here we are talking about the companies that reside within the industries that provide goods and services that consumers, governments and the economy as a whole will need come rain or shine.
A simple example would be household non-durables (things that get used up quickly) like toothpaste, shampoo, shaving cream, etc. Regardless of whether the economy is booming, people will still need to brush their teeth, wash their hair and shave. Despite this, there is still an element of stock selection within historically defensive industries. (For more on this topic check out Cyclical Vs. Non-Cyclical Stocks.)
As all these tips suggest, caution is the name of the game. By having your money on the sidelines or invested in bond funds, value stocks, defensive industries and, under certain circumstances, on the short side of a stock you'll be well-positioned to endure a bear market much more gracefully. Adopting strategies like dollar-cost averaging, staying realistic and avoiding panic will also help you keep your assets out of harm's way.