Surviving Bear Country
A bear market refers to a market-wide decline in stock prices of at least 15-20% coupled with a pessimistic sentiment about the market. Clearly, these times are nothing to look forward to, and fighting back can be dangerous. But don't despair - there is hope! Here we will walk you through eight important investment strategies and mindsets to help you stay calm and play dead when the stock market taking a swipe at your returns.
Keep Your Fears In Check
There is an old saying on Wall Street: "The Dow climbs a wall of worry." In other words, over time the Dow has continued to rise, despite economic woes, terrorism and countless other calamities. Investors should try to always separate their emotions from the investment decision-making process. What seems like a massive global catastrophe one day may be remembered as nothing more than a blip on the radar screen a few years down the road. (For more see our tutorial on The Greatest Market Crashes.)
Average Down Costs With DCA
The most important thing to keep in mind during an economic slowdown is that it's normal for the stock market to have negative years - it is all part of the business cycle. If you are a long-term investor (meaning a time horizon of 10+ years), one option is to take advantage of dollar-cost averaging (DCA). By purchasing shares regardless of price, you end up buying shares at a low price when the market is down. Over the long run, your cost will "average down" leaving you with a better overall entry price for your shares.
During a bear market, the bears rule - and the 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 met 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 in money market securities such as certificates of deposit (CDs), U.S. Treasury bills, and other instruments with high liquidity and short maturities. For more insight, see Are CDs Good Protection For The Bear Market?
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. A proper asset allocation strategy will allow you to avoid the potentially negative effects resulting from placing all your eggs in one basket. For more on asset allocation, see Asset Allocation Strategies and A Guide To Portfolio Construction.
Invest Only What You Can Afford To Lose
Investing is important, but so is eating and keeping a roof over your head. It's unwise to take short-term funds (i.e. money for the mortgage or groceries) and invest them in stocks. As a general rule, investors should not get involved in equities unless they have an investment horizon of at least five years, but preferably more - and they should never invest money that they can't afford to lose. Remember, bear markets, or even minor corrections, can be extremely destructive.
Look For 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 such as Warren Buffett often view bear markets as buying opportunities because the valuations of good companies get hammered down along with the poor companies and sit at very attractive valuations. Buffett 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 nature is to punish even good companies by more than they deserve.
Take Stock In Defensive Industries
Defensive or, non-cyclical, stocks are securities that generally perform better than the overall market during bad times. These types of stocks provide a constant dividend and stable earnings, regardless of the state of the overall market. Companies that produce household non-durables - such as toothpaste, shampoo and shaving cream - are examples of defensive industries because people will still use these items in hard times. For more see Cyclical Versus Non-Cyclical Stocks.
Consider Inverse ETFs
Inverse exchange-traded funds (ETFs) give investors a chance to profit from a decline in major indexes or benchmarks such as the Nasdaq 100. When the major indexes go down, these funds go up, allowing you to profit while the rest of the market suffers. To learn more about this investment strategy, see Inverse ETFs Can Lift A Falling Portfolio.