Bear markets are a fact of life, but it can be hard to anticipate them, know how long they will last, or how severely they will impact stock prices. Bear markets are a natural part of market cycles. Not only can you survive them, but you can also position yourself to benefit from them. Below are some techniques you can use to either reduce your portfolio losses or even to make some money off the bear market.
What Is a Bear Market?
A bear market is when prices of securities fall sharply, and a sweeping negative view causes the sentiment to further entrench itself. As investors anticipate losses in a bear market and selling continues, pessimism grows. Although figures can vary, for many, a downturn of 20% or more in multiple broad market indexes, such as the Dow Jones Industrial Average (DJIA) or Standard & Poor's 500 Index (S&P 500), over at least a two-month period, is considered an entry into a bear market.
When stocks begin to fall, it's hard to know when they will reach their bottom. If you wait too long and stocks rise again, you’ve missed an opportunity to buy on a dip and won’t profit from the rebound in prices. But if you are too quick to pull the trigger, you may see your new stock purchases continue to decline further. It can be tricky to identify the best timing in these cases and to manage active trading at the onset of a bear market.
A 10% correction is not the problem. Most investors can stomach that. It's the 78% correction, as we saw with the tech bubble bursting from 2000 to 2002, or the 54% lost by the Dow Jones Industrial Average between 2007 and 2009, that makes most investors succumb to fear and lose money.
Oftentimes during a bull market, a 10% correction will cause Wall Street cheerleaders to calm the public with, "Hold on, don't panic, buy more" and suggest buying dividend stocks as a hedge. But if you go all-in when the market falls 10%, and then it falls another 40% or 50%, that 5% dividend is often a very small consolation in light of the money you've lost.
So then what can we do to really cushion our losses, and even make some money in a bear market? Here are four strategies for overcoming the next bear market:
Strategy 1: The 401(k)
One lesson from the bear market of 2007-2009 is that if you buy index funds at regular intervals through a 401(k), you will prosper when the market finally does rebound. Those who used this strategy didn’t know whether the bear would end in December 2007, June 2008, or as it finally did, in March 2009.
Some investors say their 401(k) was cut in half by the time the bear market ended, but all of the shares that were bought on the way down became profitable when the market finally turned around and climbed higher.
By 2015, those who hung in there had made enormous profits from the cheaper shares purchased during the downturn, plus company matching, plus all of the money that they got back (and then more profit) from the shares bought before the peak in 2006-07. The moral of the story is it’s best not to go all-in at any one time, but to just keep investing small amounts at regular intervals.
Strategy 2: Buying Short- and Long-Term Puts
If you feel that a bear market is developing and have substantial long positions in the market, another useful strategy is to buy inexpensive short and long-term puts on the major indices. Keep in mind trading derivatives often comes with margin requirements and that may require special access privileges with your brokerage account.
A put is an option that represents rights for 100 shares, has a fixed time length before it expires worthless, and has a specified price for selling. If you buy puts on the Dow Jones Industrial Average, S&P 500, and Nasdaq and the market declines, your puts will gain in value as these indexes are falling.
Because options increase or decrease by a much larger percentage than stocks, even a small number of put contracts can offset your long stock position losses. As expiration is approaching, you have the option to sell your puts on the open market or exercise and give up the shares. Note: This is a very risky strategy and requires some experience before you try it for the first time.
Strategy 3: Selling Naked Puts
Selling a naked put involves selling the puts that others want to buy, in exchange for cash premiums. In a bear market, there should be no shortage of interested buyers.
When you sell a put contract, your hope is that the put expires worthless at or above its strike price. If it does, you profit by keeping the entire premium, and the transaction ends. But if the stock price falls below the strike price and the holder of the put exercises the option, you are forced to take delivery of the shares with a loss.
The premium does give you some downside protection. For example, let’s say you sell a July 21st put with a $10 strike, and the premium paid to you is .50. This gives you a cushion of down to $9.50 for which to maintain break-even.
With naked puts, you are on the receiving end of a derivative transaction so the best strategy can be to keep selling short-term puts on solid companies that you wouldn’t mind owning if you had to, especially if they pay dividends. Even in a bear market, there will be periods where stock prices rise, giving you profits from the puts.
Strategy 4: Finding the Assets That Increase in Price
It is helpful to research past bear markets, in order to see which stocks, sectors, or assets actually went up or at least held their own when all around them the market was tanking.
Sometimes the precious metals, like gold and silver, outperform. Food and personal care stocks often called “defensive stocks,” usually do well. There are times when bonds go up as stocks decline. Sometimes a particular sector of the market, such as utilities, real estate, or health care, might do well, even if other sectors are losing value.
Many financial websites publish sector performances for different time frames, and you can easily see which sectors are currently outperforming others. Begin to allocate some of your cash in those sectors, as once a sector does well, it usually performs well for a long period of time. Bear markets can also have different catalysts, so this strategy can also help investors allocate accordingly.
The Bottom Line
So as you can see, we do not have to fear a bear market, but rather by employing some alternative strategies, we can do quite well during those times when many others are suffering major losses in their portfolios.