Five Tips for Investing During Market Downturns
Younger investors might not remember the bear market of 2008. It began on October 9, 2007, when the S&P 500 closed at 1,565.15, and ended on March 9, 2009, when it closed at 676.53. The S&P 500 didn’t fully bounce back until it closed at 1,569.19 on March 28, 2013.1
It was a harrowing experience for those of us who watched our investment and retirement accounts tank during this period. However, it also provided opportunities for those who kept a level head. The following is an overview of bear markets and tips to help you prepare for the next one.
What is a bear market?
The Securities and Exchange Commission (SEC) defines a bear market as, “a time when stock prices are declining and market sentiment is pessimistic. Generally, a bear market occurs when a broad market index falls by 20% or more over at least a two-month period.”2
While a 20% drop is the minimum for a market to be considered a “bear,” prices often decline significantly more during these volatile periods. We experienced a 57% decline in the S&P 500 during the 2008 bear market. Bear markets often, but not always, coincide with an economic recession, which is defined by two consecutive quarters of negative economic growth as measured by gross domestic product (GDP).
Bear markets and recessions can be caused by several factors, including:
- A market bubble burst (when overly optimistic asset prices drop to more realistic levels)
- Geopolitical crises or wars
- A sluggish economy
- Drastic changes to tax rates or interest rates
- A pandemic
Bear markets can last from a few months to a few years. They typically end when stock prices reach the point of maximum pessimism. At this point, investor, consumer and business confidence begins to recover and market prices start climbing. Once stocks rebound 20% from their lowest point, the bear market is considered over, and a new bull market begins.
Tips for preparing for the next bear market
Here are several tips you can implement today to better position your portfolio for the next bear market.
Tip #1 – Invest for the long term
As many other Creative Planning articles mention, it’s always best to take a long-term, goals-based approach. Bear markets can be scary. Not only do you see a constant (and sometimes steep) decline in your portfolio’s value, but news outlets and other investors can often make a market drop seem like the end of the world. The one thing all bear markets have in common is that they always come to an end. When you remain focused on your long-term goals and avoid making rash, emotionally driven decisions, you will be in a better position to weather the bear market.
Tip #2 – Maintain a diversified portfolio
Regardless of the current market environment, it’s always wise to maintain a diversified portfolio. Investing in different types of assets spreads out your risk. Therefore, when one sector or investment type is performing poorly, another investment type that’s performing better can help smooth out volatility within your portfolio. Diversification won’t prevent losses, but it can reduce the risk of being too heavily invested in the worst-performing part of the market. You can diversify by combining stocks with bonds, large company stocks with small company stocks, U.S. stocks with international stocks, and stocks from different sectors, like technology, financial, energy, health care, etc.
Tip #3 – Keep cash on hand
There are several reasons why it’s wise to keep some cash in an emergency fund, such as a savings account. You may need to draw upon your cash reserves to pay for general living expenses should you lose your job, or to cover large, unexpected expenses (like replacing your furnace). During a bear market, an emergency fund can prevent you from having to sell investments at a loss to pay your bills. Selling stocks at the bottom of a market cycle will make it more difficult to recover, as you will have less money invested in the eventual stock market recovery. It’s wise to have at least three to six months’ worth of living expenses in your emergency fund to avoid tapping into your investments at an inopportune time.
Tip #4 – Commit to an appropriate level of risk
It’s important to commit to and maintain an appropriate level of portfolio risk. Consider your risk tolerance, current financial situation, future income needs and long-term goals. Hold true to this risk profile even during periods of market volatility. Having a portfolio that is too aggressive increases the likelihood that you will make an emotionally driven decision to sell at the wrong time. On the other hand, having a portfolio that is too conservative reduces long-term returns and could make it more difficult to outpace inflation and accomplish your financial objectives.
Tip #5 – Develop a bear market strategy ahead of time
Bear markets are a normal and healthy part of the market cycle. Chances are high that you will experience several bear markets in your lifetime. Having a strategy in place will increase your odds of coming out of one in better shape than when it began. The depth of a bear market is a terrible time to sell stocks, but it can be a great time to buy stocks. Assets that hold up better during bear markets, such as high-quality bonds, can be sold to add stocks at lower prices. This practice is referred to as rebalancing.
Tax harvesting is another strategy to consider. Assuming you have a taxable investment account and some of your investments have dropped below their original cost, you can sell those investments to harvest the tax loss. You could then immediately buy a similar investment to catch the eventual rebound. You cannot buy the same, or a “substantially identical,” investment back within 30 days before or after selling it, or the IRS will disallow the loss. Capital losses can then be used to offset any capital gains, effectively reducing your tax bill. Any unused losses can be carried over to offset gains in future years, and you can use up to $3,000 in carryover losses to offset ordinary income each tax year.
At Creative Planning, we help clients make smart investment decisions throughout all phases of the market cycle. Please schedule a call if you’d like help preparing your portfolio for the next bear market — or with any other financial matter. We look forward to working with you.