With the S&P 500 hitting new all-time highs this week, it may seem like an odd time to talk about preparing for the next bear market.
But it isn’t.
Bear markets – defined as a decline in the index of 20% or more – are simply a fact of life. In my last column, I noted their average frequency, depth and duration.
The time to get ready for a bear market is before it hits… not after.
You can do this three ways:
- Make it personal.
- Do a portfolio pre-mortem.
- Take six important steps.
What do I mean by making it personal? Look at the size of your stock portfolio. Imagine – really visualize – what it would feel like to see it decline, even temporarily, by 32%. That’s the peak-to-trough decline of the typical bear market.
That means you may be more conservative and less tolerant of a prolonged downturn.
This is particularly important if you are out of the workforce and won’t have the cash flow to take advantage of low prices in a severe downturn.
Next… do a portfolio pre-mortem.
A pre-mortem is a strategy where you imagine that a devastating bear market has just hit and you work backward to determine what you could have done to minimize the damage.
Avoid the temptation to say, “I could run to cash.”
The problem with going 100% to cash (or bonds) is the market may continue going up not just for weeks or months but years. And the longer you’re out, the higher the market may go.
If you stay on the sidelines long enough, stocks may never come back to where you cashed out. And if you jump back in, you risk being in for the correction after missing the rally.
There are six better and more effective steps you can take today to prepare for the next bear market:
- Rebalance your portfolio. After an 8 1/2-year bull market you may have more in stocks than you realize – or than you’re comfortable with. Reduce your exposure to the asset classes that have appreciated the most. And add the proceeds to those that have lagged the most. (Important note: I’m talking about asset classes here – stocks, bonds, real estate investment trusts, etc. – not individual securities.)
- Make your asset allocation more conservative. Obviously the smaller your equity allocation, the less your portfolio will decline in a bear market. Unfortunately, most investors are reluctant to pare back on stocks in a bull market for fear of missing out on further gains. (And later they don’t want to increase their stock holdings in a bear market because they don’t want to risk further declines.) Do it anyway. It may feel counterintuitive, but it works.
- Favor large caps over small caps and value stocks over growth stocks. History shows that these more conservative assets hold up far better in a down market.
- Favor dividend payers over nondividend payers. Dividend stocks are less volatile – and over the long haul higher returning – than companies that don’t pay them. They give investors a reason to hang in there when the going gets rough. Plus, they can be reinvested at lower prices in a down market.
- Diversify globally. Not all world equity markets move in sync with our own. The beauty of global diversification is that not only do you have access to more opportunities but those assets may appreciate when our own market is declining. International shares also offer foreign currency appreciation potential.
- Use trailing stops. And abide by them. If your “mental stops” never get executed in a real sell-off, they’re just wishful thinking. Trailing stops protect both your principal and your profits.
If you make it personal, do a portfolio pre-mortem and follow these six steps, you’ll be better off than 99% of investors when the next bear market hits.
Hold some cash too, up to 10% of the value of your portfolio. Yes, it’s boring and low-returning when everything is going up.
But no one says “cash is trash” when they’re capitalizing on new opportunities at great prices.
Source: Investment U