During a decline in the economy, investors are quick to seek out safety in their investment holdings. Instead of sticking with an asset allocation that represents a diversified portfolio, logical trading strategies are replaced with emotionally charged sell-offs of otherwise high-performing investments. Despite sound investment principles, investors shift their losing equity positions to more stable, less volatile investments including cash and money markets, short-term debt securities and defensive stocks. These investment options hold the least amount of market-related risk when the overall economy is in a tailspin.
Cash and Money Markets
For the average investor, a decline in the markets that lasts more than a few months is enough of a catalyst to move out of an equities-heavy portfolio. The most common place to set aside funds from that sell-off is a cash or money market account. A cash account, most commonly in the form of a bank or credit union savings account, is not tied to the stock market and as such, presents little risk to investors. A money market account, either offered through a bank as a deposit account or through a brokerage platform as a mutual fund, is also a common holding place for funds recently removed from the grip of the stock market. Both savings and money market accounts provide investors a medium to earn interest without the risk of market fluctuations. Money held in cash or money market accounts can easily be invested back in the markets once the investor feels comfortable enough with performance.
Another safe move by investors in a bear market is to place recently traded equity securities into short-term debt securities which is most commonly achieved through the purchase of U.S. Treasuries. These shorter-term government bonds are inversely correlated to stock markets, and as such tend to rise in price as stock prices fall. During a bear market, trading strategies shift toward safety creating a much higher volume of U.S. Treasuries owned by investors. This also gives rise to price increases that in turn provide investors with more stable portfolios. Not all bonds are created equal during a bear market; investors should seek out shorter duration debt and steer clear of high-yield corporate bonds when the economy is in a decline.
In addition to cash and short-term debt, some investors can find stability in defensive stocks. Smaller, younger companies are not always able to handle the financial constraints that a bear market can impose on businesses and are therefore not the best investments to hold during economic decline. However, larger, more established companies with solid balance sheets, known as defensive companies, have a much easier time withstanding bear market conditions, and many continue to pay dividends even when the economy is stagnant. Investors can create a hedge with defensive stocks during a bear market if they do not want to exit the markets completely.