4 Steps to Prepare for the Next Bear Market
A bear market (a term to describe a period when the market is off 20% or more from its highs) is an inevitable part of investing. In fact, on average a bear market can be expected once every three years. A bear market may seem troubling at the time, but by keeping a cool head you can use a down turn in the market to your advantage. Here are four things to do in order to prepare for our next inevitable bear market:
1. Accept that a bear market is part of investing: The stock market, like anything in life, must come with both good and bad. You cannot have the day without the night or summer without the winter. The market does not go straight up. It does not consistently furnish a return of 11% per year. That may be the average over a long period of time, but within that average there are usually dramatic shorter-term swings. We must accept that these swings are just a part of investing and we will do what we can to take advantage of these swings when they occur.
2. De-leverage: Leverage is the borrowing of money at any level. Leverage could be used to buy a car, buy a home, or buy investments. The problem with leverage is that it can be a crushing burden during a challenging economic period. Remove as much leverage from both your investing and your life to avoid major financial problems during a bear market or poor economic periods.
3. Diversify: This is the old, “Don’t put all of your eggs in one basket” lesson. Diversification is the one strategy for your portfolio that will provide you with flexibility during the bear market. If you have a portion of your money in cash, bonds, real estate, commodities, and stocks, you will have assets that are most likely performing well while the market is going lower. You will then have the ability of sell some of what is doing well and purchase what is doing poorly.
Diversification will also protect the principal of your portfolio. As I’ve previously pointed out, when certain assets are declining in value. Others will be increasing. This increase in value will help somewhat offset the losses and provide the portfolio with a better total return than the market. There is perhaps no more important strategy to help you withstand a bear market than diversification.
4. Rebalance Regularly: Rebalancing your portfolio means simply selling some of what has done well and buying some of what has done not so well. Buy low and sell high, it seems so obvious. However, most investors do the opposite. They purchase what is already very expensive because it has gone up recently and sell what is cheap, because it has gone down recently.
Assume you start with a simple diversification of 50% stocks and 50% bonds. Let’s also assume the market goes up dramatically this year and bonds perform poorly. At the end of the year, I am now 65% stocks and 35% bonds. If next year happens to be a bad year for stocks, my portfolio will lose a lot more value than I originally had intended. In order to remedy this overweighting in stocks, at the end of the year I sell enough stocks and buy enough bonds to bring me back to my 50/50 allocation. Not only does it protect me from a bear market, but it allows me to sell stocks that are high and buy bonds that are low.