How Investors Can Manage the Coming Bear Market

Bear Market & Investors

All bull markets have eventually come to an end in time, and while this one could last longer, its day will come sooner or later. Do we have a plan in place to deal with this risk?

There’s always some sort of talk about bear markets, even in the midst of the best bull runs we ever see. Depending on how things are going, these concerns can grow large, although the focus on the street and in the media is more on the shorter term, where we’re headed over the next couple of months or the rest of the year.

Many investors play the long game though, for better or worse, and aren’t likely to be concerned about things like the market pullback last month and require much more dramatic moves to wish to be out of the market or even cut back on their stock positions. Some do not wish to ever do so, or at least not until they get into their later years where they will either need to take distributions or are getting close to that date.

The media focuses on every little nuance of the markets and their outlook though, and most of this is not targeted toward the long-termers, although some or even many may be confused.

There is no commitment with stocks, and even though we may choose to stay in them come hell or high water, or at least until the water gets high enough that we are cast adrift, we still do choose every day to maintain this view.

This commitment does tend to vary over time, and especially during times of relative trouble, and while none of this may reach the threshold of pain that we have set for ourselves, pain is pain, and if we are feeling some, we need to at least take heed and maybe even explore different approaches that may serve our purposes better and also make us more comfortable with our plan.

A complete lack of a plan, which is pretty common, neither has an exit strategy nor has a way to reduce whatever pain we encounter, and leaves us with no real alternative but to endure whatever amount fate may bring us. We may actually be more afraid to try to manage this pain then we are facing whatever comes, even though it may not make sense to hold this view, but fear of the unknown can be a powerful force.

A long-termer is basing his or her strategy upon the past results of most stocks going up over time regardless of the circumstances, and a lot of stocks do behave like this, even though some don’t. There are stocks that you could have been in for 20 years and still be down a lot of money, so the fact that the market usually goes up over this amount of time is by no means a guarantee that any given stock of yours will.

We look to diversify to offset this particular risk, and we can simply invest in an index such as the S&P 500 and put this concern pretty much to rest, although this still leaves us fully exposed to the risk that the index itself may be mired in a long-term decline, which has happened.

We Manage Things Anyway, Why Not Try to Manage Them Better?

We are managers of our own investment portfolios whether we like it or not, even though this may mean total lack of management, which is still a form of it. If the goal is to look to profit from investments over time though, you would think that the amount of effort and attention we’d be giving this would be a greater than zero.

There is certainly wisdom in looking to keep things simple, especially if both our attention levels and investment management skills are pretty minimal. This does not mean though that we should not make any real attempt to help ourselves, because a little help is better than none here.

Index funds are becoming more and more popular, and while we may be able to do better by taking a more active approach, going with stocks that are performing well and getting out of those which are not, this does take a little effort and skill though and we may at least think that something like this is beyond our abilities.

We could teach kids to do this though without a lot of trouble, and this would be nothing like the way college level courses teach managing investments, which tend to both overly complicate these decisions and focus on the wrong things as well. If we’re looking to manage performance, looking at performance alone should be enough, and in practice, it certainly is.

Doing this properly does not involve any crystal balls, or looking into the future at all, as this is about the present. All we really need to do is to keep our eyes upon what is happening, and to guide us, we can even act upon our intuition if we like, as our intuition is often at least pointed in the right direction, and the right direction is a better direction.

Fear of making mistakes is seen as the biggest risk, not anything the stock market might do to us. The stock market is actually pretty kind to those who apply themselves honestly and courageously though, to some degree at least and some degree is better than none. What investors should be most afraid of is just sitting back and doing nothing, especially in the face of a bear market.

If we take an all or nothing view, then this will most often leave us wondering what to do when we suffer a certain degree of loss, even though a plan like this can still be managed. Seeking to take big swings as this involves does require more skill though, as they involve decisions with both greater potential if we get it right and more risk if we do not.

An example would be right now in fact, where we might think that the market has grown tired, and together with all the potential issues out there such as trade wars and the declining economy, it might be time to pull everything out now. This is actually the antithesis of a long-term investor though, and these investors believe that nothing less than the house coming down may be worth worrying about, so they really should not be making such big decisions based upon mere speculation.

If we are prepared to pull out based upon what are ultimately shorter-term concerns, then we need to be just as prepared to get back in when the tide comes back in again. This is well outside the domain of long-term investors though and therefore just doesn’t fit their approach or preferences.

Last year’s mini-bear market is a good example of this. There were plenty of reasons why traders of various time frames, but not investors so much, would have wanted to step aside completely during that, and some may have wished to go the other way and join the bears on the short side, and this is not that hard to do anymore. You don’t have to short stocks, trade futures, or buy options to do this now, as we have inverse index ETFs that serve this purpose just fine and are easy to get in and out of, almost instantly in fact.

It is Not About Selling Everything or Not, It’s About Selling Certain Amounts

If we just plan on taking big swings at this, this leads to a wait and see approach that might just keep waiting and seeing for a long time. This is how so many people got caught back in 2008, and as they watched things deteriorate further, they waited, and each downturn propped up their hope that things may be over soon. It took a long while to get there and many investors sold only after huge losses, where doing nothing at all would have been far preferable.

Others may dilute their stock positions generally by mixing in other assets such as bonds to some degree, thinking that this is somehow a wise move, but this involves paying a price whether the market is going down or up. If it moves up, we’ve constrained our returns, and when it is going down, this causes us to hang on to things and lose more than may have been wise, giving us a false sense of security and causing us to be blind to alternatives that may be clearly better, such as reducing our exposure based upon need and not even being in stocks at some point if things get bad enough.

2008 was clearly one of those times, and given that our expectation is to see prices go up, it’s not even that easy to imagine how anyone thought that this plunge had a positive expectancy during these times. It is not enough to just say that over time things come back when we can just sidestep this and be better off whether it does or doesn’t.

We’re not looking at anything close to this sort of massacre right now, but we could see another 20% to 30% pullback at some point in the foreseeable future. All we need for this is for the crowd to start running the other way enough, and while we may refuse to join them, it’s not hard to get the crowd to move quite a way from us, like we saw late last year.

We should at least consider an approach that is both variable and tied to what is going on in the market, where as things turn sour, we reduce our risk exposure. There are a lot of options to do this, but the simplest one is to just move amounts to cash to manage this risk. When things are going down, we cut back, and when they are going up, we do the opposite and increase our exposure.

It’s not even a crazy idea to play both sides at the same time, although this will involve higher transaction costs and we can accomplish the same thing by just cutting back more. Instead of taking 10% of our stock portfolio out of an index ETF and into an inverse ETF, we can just pull out 20% and save a bit of money.

Trading costs aren’t usually that meaningful for investors though, and as a percentage of your overall portfolio value, no real investor will be trading so much that this will be meaningful either way. Funds do come with management fees though and it’s just better not to pay them when you can just hold cash instead and get a little interest on your money instead.

People also worry about optimizing such a strategy too much, and while we don’t want to be foolish with this and either be way too fast on the trigger or have our guns stuck in their holster when they should be used, anything that limits our risk and improves our returns is going to beat doing nothing.

If we are feeling a little edgy right now, there can be some psychological benefits to this as well, where taking a little off the table can make us rest easier in addition to reducing our risk exposure to bear markets. If our fears end up being justified, and we see the market give up its gains this year and start putting in some losses instead, we’ll already have a head start and can do more as we feel appropriate. Once again, this serves both our psychological stress and our actual exposure.

We might think that this should be an all or nothing thing, and we need to just go all in and not even look at the cards that have been dealt, but even long-term investors can find a plan that has them managing their risk better than simply relying on hope, by mixing in a bit of wisdom as well.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.