How should an individual go about bear market investing?
It goes without saying that the skills required to make money in the stock market are very different depending upon whether the market is rising or falling.
One real problem is that despite the likelyhood of every private investor being faced with a bear market, not many of us are equipped with the real knowledge and skills to prosper through one.
Could you make a profit when values are tumbling?
Therefore, the real way to be able to make consistent profits through a downturn relate to education and being prepared for the situation.
As an investment adviser, the stories that some clients pass on about their own 'experience' of falling prices is pretty scary! Since, few people are skilled or knowledgable at bear market investing, it seems that many people just stop looking at daily market prices! Therefore, in their own minds, it isn't happening.
Your author, has met a number of people who operated the rather
basic strategy of "not updating my market prices online for several
months" or "not switching on my investing computer". Alas, hiding from reality is an investment decision like any other.
You, dear reader, should resolve to be much more prepared for bear market investing than this, especially if a relatively simple strategy like Dow Jones investing has been your focus. Hopefully it does not need to be said, but if you are long only in every asset that you own, any sort of recessionary environment could be very painful.
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It is worth pointing out that the best strategy for wealth protection or capital gains will depend on the surrounding economic conditions. The actions you might consider in times of deflation should be very different to those considered in times of high inflation.
Essentially, there are just a few main strategies for self-protection and, hopefully, prospering during a downturn. These strategies include:
> Flight to safety. If markets are choppy and volatile and the general trend is downwards, why be in the market? In difficult times, the NYSE and NASDAQ can be very expensive places to store wealth. Why not, instead, sell a worthwhile percentage of holdings and move the money into either cash or bonds (medium and long term government or corporate debt). As and when prices and volatility seem to have settled, and hopefully, there is some value to be found, assets can be repurchased.
Typically the US dollar and US
Treasuries are considered the safe asset into which money is parked. Other safe haven assets include gold, cash and the bonds of other developed nations (the UK and Germany are two favourites).
> Buy defensive assets. In every phase of the business
cycle, there are some assets which rise in price whilst others are
falling. This is also the case in the stock market. It is all about recognising that if there is a recession investing becomes more difficult. Some sectors will
rise whilst the market generally is falling. It is therefore possible to
stay in the market and make returns. Typically some of the more defensive
sectors include pharmaceuticals, tobacco, energy and food retailers. It is hard to imagine that there are any firms that consider themselves to be bear market companies, but there are clearly some sectors and types of business that benefit from the downturn.
> Buy units in a 'bear fund'. Some mutual funds are
designed with downward market movements in mind. These funds often show
very poor returns as the stock market rises. In long bull runs,
ownership of these funds can be justified as portfolio diversification,
but is more likely to be very costly! Therefore, these bear market mutual funds are not generally very popular with the investing public and tend to be used by a more specialised and sophisticated investor.
> Sell Index tracker funds. There is quite a body of research that suggests that while index tracker funds can offer great value exposure to the economy, the funds perform quite poorly on the way down. Why is this? Simply put, with no manager discretion to hold more cash or reduce exposure in some weaker sectors or companies, index tracker funds tend to be at the mercy of the market. Additionally, it tends to be the largest companies and headline indices that are hit the hardest in the short term and it is these that most index trackers are following. Therefore, it might be wise to sell your units before they fall too far in value.
> Sell the winners. Often during a fall in prices the biggest losers were the biggest winners during the bull market that preceded it. Some companies will have been at the centre of the action on the way up and will likely have a large number of speculative holders that will dump their holdings at the first sign of trouble. These people often were not bull market investing carefully, but gambling. Try not to be in their way when they stampede for the exit on the way down.
There will also likely be heavy selling in the largest of companies, not because their trading situation has changed, but because they are the most liquid on the stock exchange and are therefore the easiest to sell. Conversely, many very small quoted companies have such little liquidity that they will hardly be sold at all - because there is nobody trying to buy on the other side of the trade.
> Respect your stop loss numbers. During a bear market capital can be eroded or wiped out very quickly. If your financial situation is such that you do not feel able to hold on permanently through thick and thin in the way that Mr Buffett suggests, perhaps tracking your stop-loss numbers (explanation here) closely and following them mechanically will provide useful discipline.
> Trade in the market. An aggressive bear market investing strategy is to actively profit from the price falls. Historically, this is known as "short selling" or "going short". The process essentially involves the trader selling shares which they do not actually own. The hope is that when settlement day comes, the shares can be bought back in the market at a lower price and the trader will make a profit from the difference in prices. Often these kinds of trades involve leverage as do many other day trading strategies.
Large funds (especially hedge funds) will borrow on margin buying investing insurance for their portfolio. By selling short stock market assets or an index it is possible to 'hedge' positions and reduce risks.
In many countries, and on many markets, short selling is frowned upon and may well be illegal. The legality of the procedure should be investigated before making a trade. As markets have progressed and become much more technical with ever more trading options available, short selling is not the only route to profits. For example, it is possible to bet on the downward movement of a company price or the market in general by using options or spread betting. For more thoughts about possible investment strategies when prices are falling, we suggest reading this pdf.
The general health of the market is vital to this approach. If prices are simply falling, day after day, then going short might make sense, especially if you can identify weak companies with business model or profitability problems. If such companies were struggling in normal times, they will really be under pressure when the market is falling as well.
However, in some conditions, prices might be jumping around wildly. In mid to late 2014, for example, there were lots of structural issues for markets to worry about but prices mostly powered ahead. But there was very high volatility in this period so the Dow Jones was rising and falling 200 points or more every day. If you have taken a leveraged position in these circumstances, then it is only a matter of time until you bet one way and the market goes the other and you are wiped out. A trader needs to be very careful in such conditions.
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