Benefiting from Bear Markets

From the perspective of many investors, bear markets mean that we’re going to see the value of our portfolios decline, and need to patiently wait them out until we hopefully get back to where we were before the bear market started.

If we wait long enough, or are able to, this at least has always happened in the past, no matter how much a bear market may have taken from our mark to market portfolio valuations.

We therefore often see these excursions against us as temporary phenomena, and provided that we get back to where we were one day and keep moving forward, we feel good about our strategy. Whether or not this happens within a given investment time frame is another matter. Bear markets can last 10 years or more, and take even longer to get even, but this is the idea in principle anyway, to just wait them out and hope things end up in our favor.

One of the curious things that investors think is that if the market and their portfolio does come back as they hoped it would, they consider this a victory as well as a confirmation and even a vindication that their buy and hold strategy is a good one and worked out.

What we need to realize though is that the goal of investing is to make not only a profit but as good of a profit as we can, or at least that should be the goal, and just because something worked out profitably does not mean that it was the best approach or even a good one.

If, for instance, we can just be out of the market for a good part of these declines, and we don’t need to even come close to timing things with any real accuracy as it is enough to be out for any sort of loss just to beat holding our positions, then this adds to the overall profitability and return on our investments.

If we can manage to be out of the long side of our positions during a good portion of bear markets, this is even better, and this approach alone can significantly add to our returns.

Cutting Our Losses Is Not That Difficult

So, we don’t need to be a market wizard or anything close to it to benefit here, the people who predict tops and bottoms with a surprising degree of accuracy, the people who sold for instance when things started going sour in 2007 and bought back in 2009 close to the bottom, we just need to strive for being on board for a good part of these pullbacks to have us considerably better off. This is not really hard to do, as even the most uninitiated investors can usually tell whether we’re in a bull or bear market, for instance the fact that when things started going down quickly in 2007 that wasn’t a bull market, or the fact that we are in one since the rebound from that in 2009.

We don’t even want to try to trade tops and bottoms, as a certain amount of movement against us is required to determine whether a move is significant enough, for instance seeing the market decline in a meaningful enough way to want to exit, or advance from a bottom enough to indicate a good entry.

We don’t even need any sort of technical understanding of things like charts, price movements, momentum, fundamental market indicators, macroeconomic data, or anything of the sort to at least be in a favorable position relative to just holding and taking the pain during these bear markets.

Mere common sense is even enough in fact, at least enough to have us being able to make some rather crude but still valid determinations of momentum, although if we strive to become even better at doing this, the potential is there for more to be sure.

There are some caveats here though, as we can’t just be too flighty with our decisions lest we end up getting in and out of positions too often, and we do need to match what drives our decisions as far as markets turning with our desired investment time frames.

Those who for instance are looking to shoot for the longer term, as most investors do, won’t want to be put out by what are fairly modest and less meaningful pullbacks from this perspective, where shorter term investors may see these moves as plenty reason enough to exit.

Traders will see pullbacks on a daily chart as reasons to exit, and not just big ones either, the sort of things that you see on charts every day, but that’s because their time horizon is so much shorter and these small movements against them are very significant to their time frame.

So, the first thing we need to put into place is a way to decide what is meaningful to us and our plan and what is not, and make sure that we’re not trading the less meaningful ones just to turn around and re-enter when it turns out that the movement against us really wasn’t significant enough.

This is not that hard to do though, and as we learn to do this well, this can take us well beyond the common view on the street and with the public about whether we’re in a bear market and apply more accurate and timely decisions to when the larger reversals that we’re looking for when investing longer term are likely manifesting.

All of this will have us looking to benefit ourselves by seeking to be in when the going is more good than bad and be out when things are more bad than good.

This not only seeks to become more profitable and achieve better market returns over time, it also serves as a hedge to manage our risk, and the risk management part is actually at least as important as increasing our returns, if not more so. Market timing allows us to approach both returns and risk in a superior manner over doing nothing, especially the ignoring of risk altogether that buy and hold approaches commit.

Looking to Actually Profit from Bear Markets

Once we’ve gotten to the stage where we can at least be more right than wrong about predicting broad trends such as bull and bear markets, this not only provides us the means to improve our investing results by being out during bear markets, it also provides us a means to profit from them.

We are so focused on the long side that we often cast off ideas of profiting from downward movements, and also tend to misunderstand the merits of seeking to do so. Shorting scares a lot of people, especially investors, and especially those who are focused on holding things for a decade or two.

Here’s where the major source of this misunderstanding comes from. Investors do tend to think of just buying something, going long in other words, and just holding on to them, and don’t really think about timing these investments very much, save for the huge pullbacks where they may indeed time them, although not usually not well, an out of a sense of panic rather than sound judgement.

Stocks have historically increased in value over the long term, and this has allowed investors to simply go long and hold on and often do fairly well. Since the long term bias is to the upside, trying to do this with the short side, using a short and hold strategy if you will, would be rather foolish indeed.

The expected return from such a strategy would be negative based upon the long term trend continuing. Going long with no risk controls is risky enough, but at least you are swimming with the long term tide with these long term plays, but with shorting, if you have no risk controls you are holding something long term and bucking the long term trend as well with no means of protection.

This is simply a horrible idea of course, but what we need to realize is that when we time markets we do use risk controls, and this risk management isn’t any different in practice using it from either the long or the short side.

If we’re going to hold long positions when the trend is in our favor and exit when it is not, we can do the same thing with short positions, holding them when the trend is in our favor and closing them when things reverse.

In terms of the relative risk of doing this on the long versus the short side, long side investing that is actively managed this way is riskier than managing short side positions, because long positions can collapse more quickly and are therefore inherently riskier.

Bull markets tend to be longer lived and manifest more gradually, while bear markets can strike more quickly and be considerably more violent. Managing risk is all about protecting ourselves from such risk, by seeking to limit movements against us, and therefore managing risk with long positions is actually more challenging if anything.

If one seeks to short markets without due regard to risk though, this is a different story, and it is only those who look to actively manage their positions and time markets beneficially who are in a position to ever want to do this on the short side as well.

Putting This Idea Into Practice

Provided one does know when to be long and when to be out, looking to be short instead of flat during bear markets becomes a simple matter indeed, and actually requires no more thought. When we time markets, we both determine when to get out and when to get back in, and when you exit the long side you can just enter the short side, and vice versa.

The idea here is not to look to be right with these decisions all the time, and being wrong is part of the process in fact. This is a lot like traders losing half or close to half the trades they take, they are just playing probabilities, and in the end what matters is what kind of return they make and how well they manage their risk, not their batting average.

Striving for a higher batting average can actually be detrimental, as this will usually involve us passing on profitable trades while we wait for higher probability ones. Having a positive expectancy in a trade is always enough though over being flat with no positive expectancy.

This applies to investing as well, and if a certain strategy does have a positive expectancy, where for instance reversing our positions and going short is more likely to make money than lose it, and we’re managing risk properly at the same time, which sound market timing serves to do, then we benefit by doing this.

It’s not always easy to maintain one’s perspective when a trade or decision ends up going against us, but we must if we are looking to take advantage of this strategy. There are no crystal balls with investing, but we must also understand that one is not needed.

The easiest way to pull this all off is by focusing on indices and using exchange traded funds, or ETFs, for both our long and short positions, and we can even buy inverse ETFs based upon indices such as the S&P 500 if we’re more comfortable with that.

Inverse ETFs in fact help bridge the psychological gap that people have towards shorting, since they are actually still long something, buying it to sell it later at a profit from the price increasing, only with these investments we make money from the price of the underlying indices going down rather than up.

There is a lot more opportunity playing both sides though and all we need to do in order to pull this off is to be able to decide whether the bulls or the bears are in control, and then just be on the stronger side.

Investing is really just betting on one side or the other, and there’s nothing particularly special about betting the price of something will go up rather than betting it will go down. If we consider placing bets in either direction, we can really help ourselves here.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.