Bear markets are a scary time for all involved. Stock prices are tanking, and both unemployment and uncertainty are likely on the rise. The good news is, downturns are the single best time to invest.
What is a Bear market?
If you’re not aware of what a bear market is, I’ve likely caught your attention. If you are, don’t worry, this explanation will be short. We enter a bear market when the stock market falls 20% from its peak. That’s it, and although bear markets are bad, the good news is that in Australia the average and median declines of a bear market is 32%. That means that by the time it officially becomes a bear market you’re generally already two-thirds of the way through it.
How Is a Bear Market Different to a Market Correction?
Corrections can often be confused for bear markets as they are very similar. Both describe a section of the market cycle where prices and valuations are declining. A correction occurs when stocks have fallen 10% from their peak. If prices continue to fall until they are 20% from their peak, we will have officially entered a bear market.
How should I Invest During a Bear Market?
If you think bear markets seem scary, you’re right. Many people find it extremely difficult to watch their portfolio fall 1% over a day, let alone 20% over a month. Bear markets make people do crazy things, what crazy things you ask? Sell. They sell at what is literally the single best time to buy and single worst time to sell. So how should you handle the bear market? Glad you asked.
As we discussed in Investing for Beginners, you should always have an emergency fund in place, and you should never invest more than you can afford to lose. Coupled with the fact that most of your investments are likely in an index fund or funds rather than individual stocks and there is absolutely no reason to sell anything. I’ve mentioned this before, but there have been 19 bear markets in the past 120 years meaning we experience one on average every 6 and a bit years. Yet over those 120 years, stocks have increased in value an average of 13% per year. Say it with me, ‘stocks always go up in the long run’. If you sell after they have fallen, you not only miss out on the recovery but also future growth. You also incur trading fees and possibly tax. Hold everything!
This is the hardest part for several reasons. At a time when stocks have fallen 20%, there’s almost always a lot of panic in the air. So-called experts on TV will be giving differing opinions and drumming up fear leaving you clueless on how to proceed. This makes it hard enough to hold stocks left alone buy them, but that is exactly what you need to be doing. A brilliant man by the name of Warren Buffet once said, ‘Be fearful when others are greedy and be greedy when others are fearful’. What you should take away from that is that when stock prices are low, you shouldn’t panic. Let other people do that, you should be excited. Stock prices rise over the long-run and stocks are mean-reverting. If shares on average increase 13% per year, but in the past 12 months have decreased 32%. At some stage, over the long-run, the market needs to not only make back the 32% lost but also the 13% that should have been made over that period. This creates the opportunity for you to benefit from outsized future gains i.e. After declining 32% within 12 months the market may need to return 15% rather than 13% over the next 10-20 years to recover that amount.
Unfortunately, we can’t know when the market will provide those excess returns, but we do know that it will. So how do you best prepare your portfolio to take advantage of the bear market? The answer is average-in, you should make regular investments using the same amount of money while the market is falling. If you do this during both the bull and bear markets, it is referred to as dollar-cost averaging and the way it that it lowers your cost per share by enabling you to purchase more stocks when their price is depressed. As an example, if I invest $1,000 a month and I dollar-cost average, I will receive 10 shares when the market is selling for $100 per share but when the price drops to $50 my $1,000 now buys 20 shares. You may have expected to see my cost per share at $75, but as I invested the same amount of money when the market was down, I was rewarded with twice as many shares. This will bring out my cost per share down to $66.67 ($2,000 / 30 shares).
You now know the smartest investing moves that you can make during a bear market. The problem is that when one occurs the most difficult part won’t be knowing what you should do, it’ll be pulling the trigger and actually doing it. It’s not easy to go against the grain by investing when everybody else is running for the hills. Bear markets often create an environment where jobs are less secure, and you may not feel comfortable investing your excess money during that period. If you’re one of the unlucky ones at the time, you may not even have the income to invest. For this reason, it’s incredibly important an emergency fund ready. It gives yourself the best opportunity to prosper during the toughest times by allowing you to hold existing investments and add to them regularly.