Taking The Bite Out Of A Bear Market

By Chris Seabury AAA

A bear market is defined as a decline of 20% in the following three major stock market indexes:

This is determined from the highest close to the lowest close. Since 1926, the typical bear market has lasted an average of 1.3 years. These types of markets do not drop in a straight line; instead you see a 10-20% decline followed by a strong rally. Bear markets are also accompanied by tremendous amounts of fear, which often causes investors to make poor choices. So how can you balance your portfolio when everything seems to be going down? Read on for some tips on how to protect your portfolio until the bulls come charging back.

1. Dividend Stocks
One way to balance out your portfolio during bear markets is through dividend stocks. A dividend stock is a stock in which a taxable payment is declared by a company's board of directors (B of D) and is given to the shareholders from the current or retained earnings that occur, usually on a quarterly basis. They are mainly in cash but can also come in the form of stock. Dividends are generally used by stable companies to provide an incentive for investors to own their stock. (To learn more, read The Power of Dividend Growth.)

What to Look For
A key to picking dividend stocks is to find those companies that have a history of paying a steady, uninterrupted dividend over many years. Most companies that have a consistent history of paying dividends are committed to continuing that policy. Each company should have a consistent five- to 20-year history of either paying its dividend or raising it. This is a sign of financial strength because a company needs cash in order to consistently pay a dividend over a long period of time. Also, a rising dividend usually means that a company has shown promising growth in the past and can be trusted to deliver solid earnings in the future.

How They Can Benefit You
Historically, studies have shown that returns from both consistent dividend returns and increasing stock prices outperform all the major stock market averages over time. Regular dividends can provide you with income that you can receive while you own the stock. In addition, companies that pay dividends steadily over long periods of time usually are more stable during bear markets than other stocks. (For more insight, see Dividends Still Look Good After All These Years.)

2. Preferred Stocks
Another way to balance out your portfolio during bear markets is through preferred stocks. A preferred stock typically pays a fixed dividend before any dividends are paid to common stockholders. In the event of liquidation, they represent partial ownership in the company and receive priority over common stockholders but after bondholders. Owners of preferred stock do not enjoy the same voting rights as common stockholders. The advantages of owning preferred shares include a greater claim on the company's assets and having a higher priority status in terms of receiving dividends. (To learn more, read Knowing Your Rights As A Shareholder.)

How They Work
The following are four types of preferred stocks:

  • Cumulative Shares: These shares have dividends, which build up if the company does not make the dividend payments as promised. Most preferred stock comes in this form.
  • Non-Cumulative shares: These shares do not allow unpaid dividends to build up.
  • Participating Preferred Shares: These shares receive a regular dividend and allow owners to participate with common stockholders in extra dividends.
  • Convertible Shares: These shares can be exchanged for another type of security, usually common stock. (To learn more, read A Primer On Preferred Stocks.)

How They Can Benefit You
Since 1900, preferred stocks have had an average yearly return of 7.4%, while corporate bonds have averaged 6.4% and common stocks have averaged 10%. Buying preferred stock will allow you receive a consistent income during the bear markets, which can be used to balance out any losses from declining asset values.

3. Fixed Income
The following are two different types of fixed income investments. Both can be used as another way to provide balance to your portfolio during bear markets.

Certificates of Deposit
A certificate of deposit (CD) is a savings certificate that has a stated maturity date, interest rate and can be issued in any amount. They are usually issued by commercial banks and are insured by the Federal Deposit Insurance Corporation (FDIC). Generally, if you withdraw funds prior to the maturity date, you will usually incur a penalty. These investments are not tied to the stock market and can be used to provide your overall portfolio with stability. They are generally an investment for risk-averse investors, but they offer a higher rate of return than money market accounts. (To learn more, read Are CDs Good Protection For The Bear Market?)

Bonds
A bond is a fixed interest asset that is issued by corporations, governments and other large organizations. They pay interest periodically and principal upon a specified maturity date. An investor who purchases a bond becomes a creditor and will not be entitled to any type of ownership rights. In the event of liquidation, bond investors have claim to the organization's income and assets.

Generally, a riskier bond will offer a higher payout to accommodate investors for the higher risk. The safest bonds are U.S. Treasury issues, because the risk of non-payment is almost zero. Municipal bonds are issued by local or state governments and corporate bonds are issued by corporations. By and large, some municipal bonds are not subject to federal income tax and in some cases are not subject to local or state taxes either. Bonds are a good investment for those who want to limit the volatility of the stock market and can be used to provide income, balance or safety. (To learn more read, Weighing The Tax Benefits of Municipal Securities.)

Conclusion
There are many ways to balance your portfolio during bear markets. The above mentioned ways can deliver income, dividends, safety, growth and overall balance. To decide how much of each you want to have in your portfolio you should consider factors such as risk tolerance and the amount of income you are looking to generate. By implementing these strategies, you will generate a consistent income and take out the volatile swings that so many investors go through during bear markets.

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