The investing decisions you make during a market crash will impact your investment returns forever. If you make the right decisions in a falling market, you can profit handsomely. Here’s how it works.
According to Bloomberg, the S&P 500 is up over 16% year-to-date. But that doesn’t mean this will last forever. In fact, many believe we’re right on the cusp of another bear market.
Now here is something that is far more important. How you handle your stock market investments during a market crash is arguably the single most important determinant of your investing performance over your lifetime.
The fact is, however, that many people lose money (and lots of it) during a stock market crash, but it does not have to be so. So let’s take a look at a possible bear market, and how we can profit during an upcoming down market.
What is a Bear Market?
Generally speaking, a bear market is when the cost of a financial investment falls a minimum of 20% or more from its 52-week high. The Dow Jones Industrial Average hit its record high of 27,088 recently. If it were to fall 20%, down to 21,670, it would be considered in a bearish market. In stocks, a bear market is measured by the Dow, the S&P 500, and the NASDAQ. In bonds, a bear market might take place in U.S. Treasuries, corporate bonds, or municipal bonds.
What Are the Benefits of a Bear Market?
Cheap Stocks = Massive Gains Over Time
If you act effectively, by not selling and rather continuing to purchase stocks, the more bear markets you experience as an investor, the higher the probability that you’ll eventually retire with a bigger nest egg. In other words, years of underperformance tend to be followed by years of overperformance. And those years of underperformance are an excellent opportunity to purchase shares inexpensively.
Other Investors Are Scared of the Stock Market
There is a simple reason why so many investors and even professional money managers are scared of the stock market–in the short term, stock prices seem arbitrary. Up one day and down the next, watching the ticker every second the market is open can cause one to wonder just what in St. Peter’s name is going on. Warren Buffett described this phenomenon like only Warren Buffett can:
“In the short run, the market is a voting machine but in the long run it is a weighing machine.”
Actually, Benjamin Graham first said this, and it has stuck with Mr. Buffett, who repeats it often. But the wisdom behind this statement should be taken to heart.
In the short term, stock prices reflect all kinds of noise. The Fed Chairman says this or that, and stocks fluctuate. Unemployment numbers come out, and the market reacts. A politician says something to get elected, and the stock market traders do their thing. The point is that in the short term (I’d say one year or less), stock prices are often the result of factors that do not bear on the long-term value of the enterprise.
When viewed long term, however, the market truly does reflect the underlying value of public companies. By long term, I mean really long term (ten years or more). Stocks can be undervalued or overvalued for a decade (see 1960s or 1990s). But given enough time, stocks will reflect the underlying value of the corporation that issued the security.
Investors Sell on Fear and Buy on Greed
While most would not quarrel with the above comments, many do not take them to heart. It is not easy to hold on to your investments when they fall 40%. You start to lose confidence in your investing decisions. Then you start to wonder if there has been some seismic shift in the markets.
Remember the Internet bubble? I recall investors talking about how the world was totally different with the Internet, and they used this lie to convince themselves to buy stocks of dot com companies with zero revenue. Remember the housing bubble? Folks would tell me that they are not making any more land, so prices must keep going up. Those folks are renting now and proclaiming that owning a home is NOT the financially prudent thing to do.
The point is that many investors do exactly the opposite of what they should do. When stocks are going up, they buy, buy, buy. When the markets crash, out of fear, they sell, sell, sell. All I can say is that this is wrong, wrong, wrong.
You Learn Your Own Risk Tolerance
A market crash presents a great opportunity to determine just what your risk tolerance is. Many mutual fund companies and brokerage houses offer a short survey to help you determine your risk tolerance.
The survey asks questions like what you would do if the market fell 20%. Would you sell, do nothing, or buy. Once you’ve answered these questions, the survey suggests an asset allocation based on your answers.
Those surveys are all well and good, but there is nothing like losing $10,000, or $100,000, or even $1 million to really gauge your risk tolerance. So after this market crash, you should know your risk tolerance very well. If you sold your investments over the past month or so, you may want to revisit your asset allocation plan. It may have been riskier than you can bear.
Intelligent asset allocation is the essential determinant of your investment returns. Handling more risk, by allocating more to stocks, leads to higher returns over the long term. We all know this.
But look, there’s no way to know how you’ll feel or how you’ll act after losing a substantial sum of cash in the stock market. So how much can you tolerate without losing sleep and bailing on your investments during a bearish market?
Among the most crucial things in investing is to understand your own self, which includes your investment behaviors. This is because we tend to be our own worst enemy. Going through a bear market is truly the only way to discover the appropriate asset allocation for oneself and what he or she can realistically handle (both mentally and financially).
Sound money management includes investing for the long term. As difficult as it may be, this means not making investment decisions based on fear. So let’s hear how you have handled your investments during this down market.
How to Profit from a Bear Market
The simple and easy way to profit from a stock market crash is to do one of the hardest things in life: nothing. “Don’t just do something, stand there!” is the best strategy, in my opinion.
Of course, this assumes that your asset allocation plan is appropriate for your investing horizon and risk tolerance. It also assumes that your investments have gone down because the market has gone down, not because you invested in some silly dot com company with no revenue.
So that’s what I’ve done. I’ve not changed my asset allocation plan. I have continued to invest on a regular basis just as before. I’ve only sold one fund, and that was for tax reasons. The proceeds will be going right back into the market to maintain my asset allocation.
That being said, there are some strategies you can take if you want to accelerate your path to financial freedom during a bear market:
1. Max Out Your 401(k) Right Now
One lesson from the bearish market of 2007 to 2009 is that if you purchase index funds at routine periods through a 401(k), you’ll succeed when the market rebounds. Those who utilized this strategy didn’t understand whether the bear would end in 2007, 2008 or as it finally did, in March of 2009.
So if you haven’t already, it’s time to bump up your contribution to max out your 401(k) this year and moving forward.
Think that’s nuts? Think you can’t afford it?
I still remember a relative who informed me that their 401(k) was cut in half by the time the last bear market ended, but all of the shares purchased en route ended up being insanely profitable when the market finally reversed and climbed higher.
By 2015, those who hung in there (like my relative) have made massive money from the cheaper shares bought during the slump. Now, throw in company matching and all of the cash dumped into the account from that, plus the shares purchased before the peak in 2006 to 2007, and you can imagine how much a portfolio could grow.
Now, it’s probably not smart to go all-in at any one time, but simply to keep investing small amounts at routine periods. After a while, you won’t even miss the money and your portfolio will be growing exponentially behind the scenes.
2. Look for Stocks That Pay Dividends
While the stock’s price is dictated by buying and selling in the stock market, a dividend comes from a company’s net income. If the stock’s price decreases, yet the company is strong, making a profit, and still paying a dividend, it becomes a great option for those looking for additional earnings.
Finding dividend-paying stocks is one of the core tenants of value investing. Just make sure you know what you’re looking for and don’t just pick a random stock because it pays a dividend. There is a method behind the madness here.
3. Find Sectors That Tend to Increase In Price During a Bear Market
It’s useful to research past bear markets to see which stocks, assets, or sectors actually went up (or at least held their own) when, all around them, the market was tanking. Numerous financial websites publish sector efficiencies for different time frames, and you can easily see which sectors are presently outshining others.
Start to designate a few of your investment dollars in those sectors, as when an industry does well, it typically carries that out for an extended period. Bear markets can also have various catalysts, so this strategy can likewise help investors to designate their investments accordingly.
4. Diversify and Shuffle Sectors by Using ETFs
It’s no secret that various sectors do well throughout the ups and downs of economic phases. For example, when the economy is seeing an uptick, a business that sells big-ticket products such as technology equipment, cars, green home improvement, healthcare innovation, and other comparable big purchases, tend to do so effectively. Because of this, so do their stocks (these are described as cyclical stocks).
When the economy looks like it’s getting into an economic crisis, it pays to change to protective stocks connected to basic human needs, such as food (i.e. grocery stores in the consumer staples sector), blue-chip energy stocks, and even clothing and some real estate (depending on where they’re located and who the target audience is).
So utilizing exchange-traded funds (ETFs) with your stocks can be a great way to include diversity and use an industry rotation technique.
5. Buy Bonds
Buying bonds is a great way to offset a bear market. Remember that a declining market typically occurs in difficult financial times. It often exposes which corporations have too much corporate debt to take care of and who is generally doing a pretty good job of dealing with their debt.
But how do you know where to start?
First, it’s helpful to know who issues bonds:
- Treasury bonds are issued by the federal government.
- Municipal bonds are issued by cities, states, and regional governments.
- Corporate bonds are issued by individual companies.
- Agency bonds are issued by government-sponsored enterprises like Freddie Mac or Fannie Mae.
Second, there are several places to look to buy bonds:
- The U.S. Treasury: You can buy bonds directly from the government through the Treasury Direct website.
- ETFs: You can buy bond funds through your existing broker to get a broader diversity and lower cost in bonds. A couple we like are the Vanguard Total Bond Market ETF (BND) and the Schwab U.S. Bond Aggregate ETF (SCHZ).
- Your broker: You can buy bonds directly through some brokers, such as E*Trade and TD Ameritrade, but the process can be a bit more cumbersome. I’d only recommend this if you already have a brokerage account with one of the firms that sell bonds, and even then, I’d consider looking at the Treasury Direct site first.
Finally, there are a few key things to look for when buying bonds:
- Credit ratings: The bond rating is a widely viewed snapshot of a business’s credit reliability. The rating is assigned by a third party bond rating firm (for example, Standard & Poor’s or Moody’s), and a rating of AAA is the highest possible rating available.
- Bond duration: A bond’s duration is an indicator of how sensitive it’ll be to market rate changes. A longer duration may signify more ups and downs when rates change, since the value of a bond decreases when rates go up.
- Additional fees: Make sure you’re not paying (or you’re at least aware of) additional fees charged by your broker when buying bonds. As I said above, you may be better off buying them directly through the government.
While this article certainly isn’t intended to be a full breakdown on bonds, this should give you enough information to get started in buying one of the better safeguards against bear markets. For more information, though, you can read our guide on bonds.
6. Short Underperforming Stocks [Advanced]
This one is for advanced investors only, and shouldn’t be attempted by novices. Short-selling is when you borrow money to buy shares of a stock, then immediately sell them. The goal then is to buy them back at a lower price, return the shares to the lender, and make a profit on the difference.
Shorting a stock is super-risky, and you’re essentially rolling the dice. Even the best investment analysis won’t guarantee a stock is going to decline in value, but in a bear market, thorough analysis can certainly help.
Here’s a video from Fidelity that explains short-selling in more detail:
7. Buy Dividend-Paying Stocks on Margin [Advanced]
Another advanced technique is buying stock on margin. You have probably seen this in your online brokerage account–the ability to use margin. Margin is basically a loan you get from your brokerage, up to a certain amount, to buy stock.
Why would you do this?
Well, if you can find stocks that are beaten-down, but still pay a dividend, you might be able to buy a bunch of shares on margin (not using your own money) and hope they appreciate in value. Plus, you add in the bonus of dividends.
Best-case scenario–the stocks rebound and you can sell them off, repaying your margin balance and profiting in the meantime. Worst-case is that the stocks continue to decline and you hope that the dividends can help recoup some of the cost.
Buying on margin is risky, so you have to know what you’re doing. But if done correctly, you can be super successful in a bear market.
Other Things to Consider in a Bear Market
Timing the Stock Market Is a Fool’s Game
I have a friend who sold all of his equity investments (a 7 if not 8 figure portfolio) earlier this year before the market crash. At a party at his house the other day, friends were congratulating him on such a wise move. So I asked him if he was going to get back into the market now. He said no. Then I asked when he was going to get back into the market. He did not know. So I reminded everybody that his decision to sell will have been a good one only if he buys at the right time, too.
Successful market timing requires you to be right twice–once when you sell, and once when you buy. And over the lifetime of an investor, you must be correct over and over and over again. Good luck.
What If I’m Hoping to Retire Soon?
Regardless of whether we’re in a bull or bear market, you should have a healthy emergency fund stacked up to protect you against fluctuations in the market and major changes in life. Once you’ve done that, you should make sure your portfolio is well-diversified. Finally, just because you’re diversified doesn’t mean you have to take on a huge amount of risk.
If you’re close to retiring (early or not), you should adjust your asset allocation based on your risk tolerance and runway to retirement. So basically, if you’re retiring in a couple of years, you may want to lean more heavily on safer investments like bonds.
Other Questions to Consider
Bloomberg outlined six key questions to consider before we enter the next bear market. I won’t solve all of these for you here (nor could I), but they are excellent questions for you to think about now, before the bear market hits:
- How bad will things get? Typical bear markets see an initial decline of 10 to 20 percent, but things can (and have) gotten much worse. Do some research on historical bear markets to build your knowledge.
- Will emerging markets outperform the U.S.? We can’t know this for sure, but it’s smart to include emerging markets as part of your asset allocation, but keep a close eye on things like the trade war and the news in countries that are considered emerging markets.
- Will actively managed funds outperform index funds? My opinion is no, but that may not be true. In some cases, actively managed funds can weather the storm of a declining market. But don’t forget, you’re paying a premium for this.
- Will managed futures provide positive performance in a down market again? You should only really be looking at futures if you’re an advanced investor. If you are, though, knowing how they’ll perform in a bear market is definitely something to think about, since it’s an opportunity to advance your portfolio.
- Will commodities provide diversification benefits? I think commodities are a great idea for diversification in a bear market, but they may not be for everyone. Do some research here.
- How will cryptocurrencies react? Crypto wasn’t really a thing during the last bear market, but now it is. This is a huge unknown, so consider it a high-risk, high-reward strategy to invest.
There’s a lot to think about with a bear market. Make sure you listen to The Dough Roller Podcast – Episode 320 – where Rob discusses this in great detail and gives even more insight than I have in this article.
The truth is, we can’t predict a bear market, nor can we predict what will happen. But what you need to do is prepare for it, and make sure you stay the course, if not increase your investment efforts. A bear market is an amazing opportunity, despite what it sounds like.Topics: Investing • Podcast • Smart Money