A bear market (a term to describe a period when the stock market is off 20% or more from its highs) is an inevitable part of investing. On average, a bear market can be expected once every three years.
A bear market may seem troubling at the time, but by keeping a cool head you can use a down turn in the market to your advantage. Here are four things to do in order to prepare for our next inevitable bear market:
Accept that a bear market is part of investing: The stock market, like anything in life, must come with both good and bad. The market does not go straight up, consistently furnishing a return of 11% per year. Averages calculated over a long period of time usually include dramatic shorter-term swings. These swings are just a part of investing, and you can take advantage of the downturns when they occur.
De-leverage: Leverage is the borrowing of money at any level. Leverage could be used to buy a car, buy a home, or buy investments. The problem with leverage is that debt can be a crushing burden during a challenging economic period. Remove as much leverage from both your investing and your life to avoid major financial problems during a bear market or poor economic periods.
Diversify: This is the old, “Don’t put all of your eggs in one basket” lesson. Diversification is the one strategy for your portfolio that will provide you with flexibility during the bear market. If you have a portion of your money in cash, bonds, real estate, commodities, and stocks, you will have assets that are most likely performing well while the market is going lower. You will then have the ability to sell some of what is doing well and purchase what is doing poorly.
Diversification also will protect the principal of your portfolio. The increase in value of some of your investments will help offset any losses and provide the portfolio with a better total return than the market. There is perhaps no more important strategy to help you withstand a bear market than diversification.
Rebalance regularly: Rebalancing your portfolio means simply selling some of what has done well and buying some of what has done not so well. Buy low and sell high, it seems so obvious. However, most investors do the opposite. They purchase what is already very expensive because it has gone up recently and sell what is cheap, because it has gone down.
Assume you start with a simple diversification of 50% stocks and 50% bonds. Say the stock market goes up dramatically this year and bonds perform poorly. The increase in value in stocks, coupled with the decreasing value in bonds, creates a portfolio that is made up of 65% stocks and 35% bonds.
If next year happens to be a bad year for stocks, your portfolio will lose a lot more value than you had originally intended. To remedy this overweighting in stocks, at the end of the year, sell enough stocks and buy enough bonds to bring you back to your 50/50 allocation. The investment rebalance not only protects you from a bear market, but also allows you to sell stocks that are high and buy bonds that are low.