How to Invest in a Bear Market?

Key Takeaways

A typical bear market will continue for a significant amount of time, providing investors with enough opportunity to adjust their strategy.

Bear market risks can be reduced while, at the same time, long-term gains can be increased by choosing higher-quality companies and diversifying one's investment portfolio.

During periods of market instability, defensive stock categories like consumer staples, utilities, and healthcare often fare better than other sectors.

Government bonds provide huge benefits for diversification and the possibility of substantial returns during economic downturns.

The term "bear market" describes when the stock market loses at least 20%. Bear markets are typically difficult to forecast and much more challenging to navigate safely. They first seem to be a typical market dip, followed by a correction, and maybe by bargain-hunting,  but it won't be long before it becomes clear that these moves were made in error.

Share prices have already started to fall when the negative trend becomes clear. This forces investors who have not yet reduced the amount of risk in their portfolios to question whether it is still rational to do so and whether or not doing so would only compound the cost of their failed efforts to time the market.

If for no other reason than that bear markets often last for more than a few months, inactivity by default is seldom the proper approach. According to the findings of Ned Davis Research, each of the 26 drops of 20% or more in the S&P 500 index between 1929 and 2021 lasted for a mean total of 289 trading days. [1]

Consequently, investors probably have more time than they believe to react to the declining fortunes of the share market. This may be done by adopting a portfolio structure that is appropriately defensive or by speculating on continuing declines.

Playing defense

During a bear market, you should check to see that your investment portfolio is appropriately diversified throughout a wide range of asset classes rather than just focusing on certain stock market sectors. The volatility that typically increases during bear markets and may lead investor portfolios to uncomfortable changes is reduced through diversification, which has the additional benefit of reducing the risk of loss.

According to the findings of one research study that looked at returns during the Great Depression, an investment portfolio that consisted of a 30% allotment to U.S. stocks, a 50% weightage in bonds, and a 20% weighting in cash would have generated annual returns that were deflation-adjusted at an average of 7.3% between September 1929 and February 1937. This figure was comparable to the average real return generated between 1929 and 1998. The 30/50/20 portfolio even beat a fully invested portfolio in bonds, highlighting the importance of having a diverse investment strategy. [2]

During declining stock prices, defensive stock market sectors, such as consumer staples, utilities, and health care, have historically outperformed more speculative stock market sectors. Most of the time, consumers want the products and services that these industries provide regardless of the state of the economy or the marketplace. They also take in a substantial amount of cash, contributing to comparatively high dividend yields. These industries are home to a huge number of firms that have good balance sheets. As a result, their stock is more likely to maintain its value during a downturn than small-cap or growth companies.

There is no time when investing in riskier equities is more dangerous than when the market is falling, but there is data to suggest that, historically, they have not outperformed investing in safer ones. This indicates that a purge of a portfolio's riskier assets during a bear market can also pay rewards over a longer period.

Selling Out

During a bear market, when it is believed that stock prices will continue to fall, an investor would be foolish not to steer clear of stock investments entirely. There is a tendency for bear markets to cause panic selling, which may persuade anybody to liquidate their stock holdings in favor of cash or short-term government bonds.

The problem is that very few investors can predict to time of the market accurately. Many investors will incur much lower long-term returns if they choose to sell their holdings during a bear market since they will lose out on the dramatic rallies that often signal the conclusion of a bear market. After they have missed the turning point in the market, some of them are likely to continue to resist change and stay underinvested for longer.

Throughout a bear market, selling all of your stock holdings may seem to be the most logical course of action. But in reality, doing so is a high-stakes wager on your ability to time the market and against the stock market's long record of rebounding from losses during bear markets.

Managing Risk

Various funding instruments are available to investors who want to reduce their exposure to equity market risk or capitalize on strategic opportunities during a bear market. They consist of long-term Treasury bonds, which are anticipated to increase in value if a recession accompanies the bear market; inverse exchange-traded funds; short positions on particular stocks; and put options, which are used to capitalize on short-term decreases in stock prices.

Structured investment products like annuities may provide downside protection while capping your potential gain. There is always a cost associated with hedging, whether shown as the option premium that must be paid or, less clearly, the maximum return that the holder of an annuity contract may earn. When applied to a stock portfolio, diversification and risk management have the potential to provide comparable advantages at a lower cost.

Shopping for Bargains

With the advantage of hindsight, it is clear that higher share prices eventually followed every bear market in the past. As a result, during each bear market, investors had the opportunity to purchase shares of stock at lower prices. The dollar-cost averaging strategy takes advantage of such chances by regularly investing in stocks in predetermined amounts of money, such as $500 per month. You could acquire more equities at cheaper and less equity at higher prices by using this strategy.

Investors certain that a bear market is set to finish soon may also purchase riskier companies since these equities tend to thrive in the early stages of recovery. However, if the anticipated bull market turns out to be another bear market rise, those stocks will likely drop down than before.

Concluding Remarks

A bear market is not for those who are weak of heart, and it is not often the best moment to take massive risks in the stock market. And that goes double for the danger of selling all your stocks and the risk of having a 100% equity portfolio. When it comes to picking stocks, it would be a good choice to diversify one's portfolio and give more weight to companies that have robust and well-capitalized balance sheets.

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[1] Evanson Asset Management. Evanson Asset Management® - Asset Allocation for Bears