HOW TO INVEST IN A BEAR MARKET
By Nick Mango
Time is money whenever a bear market strikes; and staying put while reciting the mantra buy-and-hold isn’t much of a safety net at all. In fact, investors who stayed 100% invested in equities and bonds during the most recent bear markets (late 2000 to 2003, and 2007 to 2009) ultimately suffered the full severity of each bear market’s downturn.
For those nearing retirement, and especially investors in the early years of the retirement life cycle, suffering such negative portfolio returns can have devastating consequences! Though millennials and workers in their prime have more time to recover, the stock market losses are just as severe. That’s why it is important to help grow and protect your investments throughout the inevitable bull and bear cycles you’ll encounter along the way by becoming well-versed and proficient with some of today’s more nimble and active bear market strategies.
So, what should investors really do in a volatile market situation, particularly if the pullbacks in the market are only the beginning of a much larger and more sustained recession or stock market crash?
What Are the Best Ways to Manage Investments in a Bear Market?
Well, to be clear, we’re advocating for more active (and proactive) portfolio management. That’s why, throughout the course of this two-part article series, investors will discover several practical tools and tactics for staying safe yet still making capital work in the markets, even if the worst case materializes and we once again wind up in the throes of a bear market.
Our mission today, then, is to identify active bear market investing strategies that self-directed investors, and even those with IRAs under management, might consider using in down markets. Whether moving assets to cash or cash alternative products, shorting individual stocks, sectors or indices, or using derivatives or option techniques, investors can achieve a number of valuable objectives, everything from growth and income all the way to asset protection and hedging.
Protect Profits Early On Through Timely Selling & Rebalancing
Traditionally, the worst bear market losses happen near the end. That’s why calculated, active management in the early stages may help lessen or even prevent a potential 20%, 30% or even 50% portfolio decline.
Holding onto under-performing equity investments for the duration, or while waiting for an up day on which to sell, might only prolong the pain and escalate losses. So, following what’s been a nine-year bull market — one of the longest ever — a clear starting point for any bear-proofing process would be to methodically sell a percentage of higher-risk equity positions. This accomplishes three important objectives:
- Locks in profits thereby preserving gains and preventing the risk of giving them back
- Boosts liquidity and bolsters the all-important cash component of the portfolio
- Frees up assets for calculated, new purchases
Every investor’s goals, risk profile and time horizon for retirement are going to be different, so while millennials or those with 20 years or so until retirement can likely tolerate more risk—and hold a higher percentage of equities as a result—a more conservative course might be to allocate 30% to cash (or a money market fund), 40% to equities and 30% to bonds while navigating bear market conditions. That’s actually rather simple to achieve for 401(k) retirement accounts, which can be retooled and rebalanced in seconds and with just a few clicks.
Active Investing Strategies to Combat Bear Market Conditions
In addition to moving to less risky, cash based assets, investors could also put some of that cash to work via one or more of these investing strategies:
- Shorting Stocks: While most retirement accounts (401(k) and IRAs) prohibit short selling of equities, playing the down side could be particularly profitable in bear market cycles when most asset prices tend to be falling. Interested investors might use a private brokerage account to put some cash to work in this manner but should only do so once properly educated and fully aware of any risks and regulations that come with trading stocks or other equities.
- Buying Inverse ETFs: As with pure short selling, a simple inverse ETF purchase could enable investors to make money when the market falls. However, unlike short selling, the purchase of inverse ETFs is typically permitted for retirement accounts...but not all inverse ETFs qualify. That’s because some inverse ETFs are leveraged two, three or even four times in an effort to increase positive performance in down market conditions. Such ETFs are high-risk assets that utilize margin and, for that reason, they aren’t well-suited nor permissible for 401(k) or IRA accounts. However, for investors looking for positive portfolio results in bear market conditions, a non-leveraged inverse ETF might be well worth investigating.
- Using Options: The option market is a vast and perhaps undiscovered universe for many long-term investors. However, option strategies are plentiful, and many have been gaining both notoriety and popularity in this modern era where heightened market volatility is the new normal. So, whether looking to hedge risk or boost growth and/or income in bear market conditions, trading options in a bear market could help investors achieve those objectives. Particularly amidst bear market conditions, investors might opt to learn and employ straightforward option tactics like buying cash-secured puts or selling covered calls; both of which are typically permissible for IRA accounts. Basic puts and calls can be used to generate income, play the short side of individual stocks, market indices and other assets, and are useful for hedging portfolio risk on existing long positions. In total, each broker has established its own rules for option trading in IRA accounts, and many preclude investors from utilizing more complex option techniques beyond the basic cash-secured puts and covered calls.
- Selling Futures: Self-directed investors may also opt for selling futures in qualifying IRA accounts. Futures enable access to a variety of markets, sectors and commodities; many of which are harder to reach by way of traditional investments like mutual funds or ETFs. To short an individual market, asset or equity, investors would sell a futures contract(s) for that particular asset and would stand to profit should the asset price drop, as is typical in bear market conditions. Because legal and tax implications are prevalent whenever dealing in futures, options or other derivative products, it’s important for investors to be knowledgeable and properly educated about these products and how to use them.
401(k) vs. IRA Strategies
Because the majority of individuals have 401(k) accounts through their employers, the selling and rebalancing process will involve selling some (or all) of their fund holdings in riskier sectors like energy, technology and consumer discretionary, and overweighting cash and more conservative funds that track assets including bonds, utilities, consumer staples and, perhaps, gold and commodities, global markets and real estate.
Unfortunately, most 401(k) programs offer somewhat limited reach in terms of fund choices. However, to unlock more flexibility and a broader range of investment choices, 401(k) investors might opt for:
- Target-date funds: By selecting a fund with a nearby target date, investors would effectively limit risk exposure through a more conservative asset mix that’s heavier on bonds and fixed-income vehicles than other funds with longer target dates. This can add a necessary layer of protection in volatile and/or down market conditions.
- A self-directed brokerage account: A widely underutilized feature of many 401(k) programs, self-directed brokerage accounts allow participants to become more nimble, active investors by opening up a wealth of additional, low-cost investment possibilities. A self-directed account may enable access to ETFs and individual stocks and bonds, plus ultra-conservative mutual funds and those that track sectors and asset classes that aren’t covered by managed funds in standard 401(k) accounts (like real estate, emerging market and international stocks, commodities and alternative assets).
Despite the many merits for investors, however, two recommendations about self-directed accounts would be to limit investment allocation to no more than 15% of total retirement assets and to manage expenses by only selecting low-cost funds and investments.
Elsewhere, beyond the quintessential 401(k) accounts, IRAs are known for utility and affording investors the additional freedom and flexibility to short the market using inverse ETFs as well as use tools like options which can be invaluable for generating returns despite prevailing bear market conditions.
In all, IRAs and the aforementioned self-directed brokerage accounts can provide investors ample opportunity to use a more active approach that’s better-suited for bear market conditions than traditional buy-and-hold bear market investing strategies.
Regardless of the account type, ensuring broader diversification and avoiding overexposure to any one market, sector, fund or even company stock is a valuable tactic for shielding retirement assets from the worst of any bear market.
It’s crucial to note that the bear-market investment strategies outlined in this toolkit must be combined with a proper asset allocation strategy as well.
About the Author
Nick Mango is a freelance writer and editor whose work in the investing, trading, and financial communities spans more than 12 years. He’s co-author of the book, Traders at Work (Apress, 2013), and has consistently published content across major media outlets and the Web’s most well-known and respected financial portals, including OTAcademy.com.
This content is intended to provide educational information only. This information should not be construed as individual or customized legal, tax, financial or investment services. As each individual's situation is unique, a qualified professional should be consulted before making legal, tax, financial and investment decisions.
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