It's been proved time and again that long-term investing, through good times and bad, outperforms other investment approaches. But staying focused on the long haul is tough when the market is going nowhere but down. A bear market can bring portfolio losses that take a toll on even the most ardent buy-and-hold investor, so it's important to prepare proactively for the market's inevitable swoons. Here's how.
What is a bear market, exactly?
Investing terms like "bear market" are often thrown around casually -- and incorrectly. For that reason, it's important to know exactly what constitutes a bear market and how it differs from a correction.
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Falling stock prices alone do not make for a bear market, which is defined as a stock-market decline of 20% or more from a prior peak that lasts two months or longer. The term is most relevant when describing a drop in prices for indexes made up of many stocks, such as the S&P 500 (NYSEMKT: SPY)(NYSEMKT: VOO), but it can also refer to an individual sector, industry, or stock if its decline is steep enough and lasts long enough.
If stocks are down, but not that much, it's probably a correction. A correction is a market decline that's less severe and shorter in duration than a bear market. Typically, corrections are defined as a 10% or greater decline from a prior peak price, and they last less than two months.
(And if you're curious, the "bear market" got its name because the downward, painful, and vicious decline is reminiscent of the swipe made by an attacking bear.)
What causes a bear market?
To find out what might trigger the next bear market, we can look at the causes behind past ones. The excellent 2013 Motley Fool article "Bear Markets in Modern Times" provides a quick backstory on the biggest drops in the Dow Jones Industrial Average (NYSEMKT: DIA) since the late 1960s . A price-weighted index of 30 of the most important publicly traded U.S. companies, the Dow Jones Industrial Average has become one of the most-watched stock-market barometers since its creation in 1896. While the exact same catalysts causing the biggest drops in the Dow Jones over the past 50 years aren't likely to reoccur, we can gain some wisdom from examining how they came about.
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First let's look at 1973-74, when the Dow Jones Industrial Average declined by 45%. The reasons behind this were many: unrest in the Middle East, a quadrupling of oil prices caused by the OPEC oil embargo, President Nixon's resignation in the wake of the Watergate scandal, and mind-numbingly big increases (12%-plus) in the price of goods and services, or inflation. Unlike the sudden 36% "Black Monday" crash of October 1987, the early '70s bear market was a slow-moving "mudslide," according to legendary investor Ralph Wanger of the Acorn Fund.
Double-digit inflation rates that continued into the late '70s and early '80s -- and the efforts to clear the financial logjam left behind -- were largely behind the bear markets of those years. The weight of inflation on U.S. economic activity, or gross domestic product (GDP), eventually prompted then-Federal Reserve Chairman Paul Volcker to roughly double interest rates in 1980. This dis-inflationary policy, which was meant to (and did) restrict credit to break inflation's back, caused high unemployment and economic recession -- a perfect recipe for a bear-market tumble.
Then there was the Great Recession: Between 2007 and 2009, the Dow had its worst showing since the Great Depression of the 1930s. (The index closed out 1929 at 300 and kept dropping, ending 1932 at about 60.) Lenders that had relaxed their standards and failed to secure adequate capital to back up their loans found themselves scrambling in 2007, when borrowers defaulted en masse on their mortgages. Banks were unable to digest the mountains of bad debt that ensued, resulting in a surge in bank failures, a shutdown in lending, and the ensuing bear market that impaled stock prices.
As these examples illustrate, bear markets are often caused by declining economic activity stemming from monetary policies. They're particularly likely after an increase in interest rates (generally put in place to tamp down lending and borrowing), so investors ought to pay particular attention when the Federal Reserve is increasing the target of its Federal Funds rate, or the overnight rate banks charge each other to borrow excess reserves.
Are bear markets unavoidable?
Long-term investing has paid off in the past because stocks have gone on to reach new highs after every bear market. The average bull market -- a rise in stock prices of 20% or more from their prior low -- lasts far longer than the average bear market, and as a result, investors who stay the course have historically been the biggest winners.
The S&P 500 has suffered 36 declines of 10% or more since 1950, according to Yardeni Research. The average bear market has lasted 1.4 years and lopped an average of 41% off the index, according to First Bank. Those are staggering statistics, but they become less scary when you realize that the average bull market has lasted 9.1 years and generated an average cumulative return of 473%.
Because the good times far outweigh the bad, the evidence suggests that it's folly to try to time the market. Instead, it's best to own stocks through thick and thin. That said, there are still things you can do to help you invest better during a bear market.
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Balancing your portfolio for a bear market
To ensure you can weather a bear market, investment allocation is key. That means successful investors will want to take time during bull markets to make sure they've got the right balance of stocks, bonds, and cash.
One way to gauge whether you're too tilted toward one investment: Subtract your age from 110 years, then invest the resulting figure as a percentage in stocks and the remainder in less risky assets. Why 110? Because that's arguably the longest you're likely to live. For example, a 30-year-old would invest 80% of his or her money in stocks and the rest in bonds, while an 80-year-old would invest 20% of his or her money in stocks and the rest in bonds. If you want a larger proportion of your money in stocks, then consider using 120 years for this calculation instead.
This calculation is an easy way to help make sure you're not taking on excessive risk, but it's by no means the only consideration when it comes to allocation. It's also important to consider how easily you could survive a financial blow, such as job loss, without having to sell stocks to cover the shortfall. Everyone's budget is different, but the "golden rule" touted by most money pros is that everyone should have between three and six months' worth of cash kicking around to get through any unforeseen setbacks. If you don't have that kind of financial backstop, make sure you include such a cash cushion when rebalancing your assets.
Should I buy on margin during a bear market?
It's true that borrowing money from your brokerage in a margin account allows you to buy more stock, which means you could potentially turn a bigger profit during a bull market. But losses endured in a margin account during a bear market can wipe you out. That's because the stocks you own in your portfolio are the collateral for the money you borrow on margin. If the value of those stocks falls below specific levels, then your brokerage can force you to sell your stocks or add more cash to your account to bring you back into compliance.
For example, if you have a $50,000 account and you borrow an additional $50,000 on margin, you'd have $100,000 invested in stocks. If those stocks fall 10%, that's a decline of $10,000 -- but that's a 20% loss on your initial $50,000 investment. You still owe your brokerage firm the $50,000 you borrowed, and you may have to sell stocks in your account or deposit more cash to satisfy that obligation. If your stocks fall far enough, you could lose your entire investment, plus any additional cash you contribute to the account. Therefore, using margin is incredibly dangerous during bear markets.
Should I sell short during a bear market?
Bear markets also bring a temptation to sell stocks short. When you sell short, you borrow shares from others and sell them; your hope is to buy them back cheaper later on, return them to the lender, and pocket the difference between the amount you sold them for and the amount you paid to buy them back. This may seem like a good idea during a bear market, but it's fraught with risk. Bear markets can last months or years, and there's no ringing bell to signal when stocks have officially hit their low. And because there's no cap on how high a stock can climb and no guarantee that any stock will fall, the risk to short-sellers is unlimited. Eventually, the shares you borrowed for shorting will have to be returned, and if the market is up significantly in the meantime, you could lose a lot of money.
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What are the advantages of a bear market?
There is an upside to bear markets: Many great companies wind up falling to bargain-basement prices, providing investors with the opportunity to add top stocks to their portfolios while they're on sale.
Dollar-cost averaging is my favorite way to take advantage of discount prices during a bear market. As a refresher, dollar-cost averaging means investing a fixed amount of money at a specific interval (say, every month). In practice, perhaps the most common example of dollar-cost averaging is when employees contribute a fixed portion of their checks every pay period to a workplace retirement plan.
The beauty of dollar-cost averaging is that it doesn't require you to time your investments perfectly. Most of us have heard the maxim "don't catch a falling knife"; it exists because investors are generally awful at figuring out exactly when a stock has stopped plummeting.
Because stocks can fall further than you imagine, it's wise to spread out your risk by staggering the timing of your buys. And because investing a fixed sum at lower prices allows you to buy more shares and thus lower your average cost, dollar-cost averaging may be the best way to build a portfolio that can profit when the next bull market begins.
How can I prepare for a bull market?
When a bull market gets long in the tooth or a bear market appears on the horizon, it's an excellent time to take stock of the reasons you've chosen to invest in the companies in your portfolio. If you've been keeping an investing diary, you'll have an objective, visual record of your decision-making. But even if not, you'll probably still remember the basic reasoning behind each of your stock purchases.
You'll want to make sure the factors that drove you to buy each stock in the first place remain intact. In doing this, it can be very helpful to take a tour of each company's investor relations website. For most businesses, this page is a portal to valuable information, including the company's latest annual report (10-K) and quarterly reports (10-Qs). Many companies also provide further resources, including PowerPoint presentations outlining recent performance and future plans, press releases detailing advances and stumbles, and transcripts of investor presentations, all of which can be useful as you determine whether the investment still makes sense to own.
There's a risk to this review process, though. If you extrapolate too much into a company's falling stock price or current results during a bear market, you might begin to imagine cracks in the armor of long-term stories that in fact remain intact. For example, selling shares of Priceline during the Great Recession -- say, because of fears over declining demand for airline travel and hotels -- would have kept you from enjoying its subsequent rally, from less than $200 in 2009 to more than $1,700 as of this writing. Similarly, selling Netflix when it changed gears from a CD-by-mail provider of entertainment to a streaming service would have been a big mistake -- Netflix has been one of the best-performing stocks of the past decade. To reduce the risk of selling a long-term winner too soon, keep your analysis at a high level by asking: Is my overarching thesis still true? If so, then stick it out until it isn't.
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Proper planning prevents poor performance
When I was growing up, my dad would say, "Proper planning prevents poor performance." He recited that mantra to me a lot, and I think it applies nicely to the question of how best to invest in stocks during a bear market. Humans are hard-wired to react emotionally to danger -- and that means we're not at our best when making choices during gut-wrenching, teeth-gnashing, claw-bearing markets. Before a bear market hits, we as investors can review our holdings to ensure we still want to own each one. We can plan which stocks to buy if and when they go on sale, and we can re-familiarize ourselves with margin and short-selling to remember why they are generally suboptimal during bear markets. And we can arm ourselves with the historical context behind previous bear markets, which will help us understand how and why they occur and when they might end.
All of this is far preferable to the risk of making panicked, poor decisions in the face of an account's falling value. In that sense, planning ahead is the best strategy for successfully investing in a bear market.
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Todd Campbell owns shares of Netflix. His clients may have positions in the companies mentioned. The Motley Fool owns shares of and recommends Booking Holdings and Netflix. The Motley Fool owns shares of Johnson & Johnson. The Motley Fool has a disclosure policy.