Most people agree that a 20% or greater drop in the stock market qualifies as a bear market. Predicting and navigating bear markets is challenging. A fall in the market, a correction, and even some bargain shopping that turns out to be premature all look like normal occurrences at first.
By the time a negative trend becomes clear, stock prices have already fallen, leaving investors to consider if it makes sense to reduce their portfolio’s exposure to risk at this point or if doing so will only increase the cost of their failed attempt to time the market.
While bear markets typically last more than a few months, doing nothing is never the best course of action. On average, the 26 separate falls of 20% or greater in the S&P 500 index between 1929 and 2021 lasted 289 days, as reported by Ned Davis Research.
So, investors have more time than they may realize to respond to the stock market’s declining fortunes, whether by adopting wisely protective portfolio positions or by betting on additional drops.
KEY POINTS
- Investors typically have a significant amount of time to prepare for a bad market before it ends.
- It is possible to reduce exposure to bad markets and boost long-term returns by investing in a diversified portfolio of high-quality stocks.
- Consumer staples, utilities, and health care stocks are examples of defensive sectors that do well in weak markets.
- Buying government bonds can be a good way to diversify your portfolio and can yield high interest rates even during economic downturns.
A quick look at the best ways to prepare for a Bear Market
Adopting a Defensive Role
In a downturn, it’s crucial to have your investments spread out across more than just one stock market sector. During downturn markets, volatility rises, exposing investors’ portfolios to potentially unsettling movements. Diversification helps mitigate this risk.
The average real return between 1929 and 1998 was 7.3% per year, and one study of returns during the Great Depression found that a portfolio consisting of 30% U.S. stocks, 50% bonds, and 20% cash would have provided returns of 7.3% per year after adjusting for inflation between September 1929 and February 1937.
To further demonstrate the value of diversification, the 30/50/20 portfolio even outperformed a bond-only investment strategy.
In the past, defensive stock market sectors such as consumer staples, utilities, and health care have outperformed the market as a whole during bad markets.
Regardless of the state of the economy or the state of the market, consumers have a consistent need for the products and services these industries provide.
They bring in a lot of money, too, which allows for healthy dividend payments. Large-cap companies operating in these areas tend to have more robust financials, making their stock more resistant to price drops during weak markets than smaller companies or growth stocks.
There is evidence that riskier equities have not beaten safer ones over the long term, and this is true even though they are especially risky during a bad market.
This shows that selling some of your riskier investments during a down market could have positive results in the long run.
Selling Out
Why wouldn’t an investor stay away from stocks during a bear market, when by definition stock prices can only go down further? Many investors are tempted to sell their stocks during a bear market and convert their holdings to cash or short-term government bonds out of fear.
Unfortunately, few investors can anticipate the market with any degree of certainty. The rapid rallies that typically signal the end of a bad market are missed by many investors who sell during a slump, reducing their long-term gains.
Those who fail to adjust their investment strategy in time for the market’s turnaround are more likely to maintain their defensive stance.
While selling off your stock holdings during a bear market may seem like the logical thing to do, you’d actually be betting against the stock market’s lengthy track record of fully returning from bear-market losses and on your own market timing skills.
Risk Hedging
There is a wide range of options for investors wishing to hedge their equity exposure or seize tactical chances during a bear market. Long-term Treasury bonds, which are likely to rise in value if the bear market is followed by a recession, inverse exchange-traded funds (ETFs), short bets on particular companies, and put options are all ways to profit from a drop in stock prices.
Structured investment products, such as annuities, can provide protection from the loss of principal but may cap your potential profit. The cost of hedging can take the shape of an option premium or, less visibly, the maximum return on an annuity insurance. Comparable benefits can be obtained at a reduced cost through diversification and de-risking of a stock portfolio.
Looking for a Deal
With the benefit of hindsight, investors can see that every bad market in history has been followed by higher share prices. With dollar-cost averaging, you can take advantage of these windows of opportunity by investing a set amount of money, such as $500 each month, in the stock market. By using this method, you can stock up on shares when prices are low and sell when they rise.
If you believe the bear market is nearing its end, you may want to consider purchasing the riskier equities that typically outperform during the initial phases of a rebound.
Nevertheless, if the anticipated bull market turns out to be another bad market rally, those stocks will likely take the worst hit.
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Conclusion
Bear markets aren’t for the faint of heart, and they’re rarely the time to take big risks. This is true both for the danger of being completely invested in equities and the risk of selling all of your holdings.
Even if triggered by a downward market, diversifying one’s holdings and giving more weight to companies with robust, well-capitalized balance sheets than to hype can yield substantial returns.
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