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How to beat a bearish market
In a declining stock market (also called a bearish market), such as we have been experiencing for the last several months, the first instinct of many investors is to abandon their stock holdings and hide in the treasury bonds or cash shelters in order to reduce their losses. It is a classic case of what financial professionals call "chasing performance", meaning trying to jump onto a ship that may already have sailed. There’s a better way to succeed when the stock market is slow or volatile: a well-planned and executed policy of asset allocation built for the long term.
Asset allocation means building a long term portfolio composed of a mix of securities including growth stocks, value stocks, bonds, T-bills (Treasury bill) and cash, along with rebalancing of the portfolio from time to time. Asset allocation is actually the opposite of market timing.
Market timers try to predict market highs and lows and get on the sunny side of the swings, a nearly impossible task. Market timing advices are seen in many newsletters and books written by so called financial gurus. However, most of these gurus probably don’t know how to time the market, other wise they wouldn’t have time to publish these newsletters since they were too busy counting all their huge profits. It may sound solid evidence against market timing, but bear market can be very frustrating and can quickly transform rational investors with a 10 years investing horizon, turning them into market timers who analyze their portfolio on a weekly and even daily basis. Since the market tends to be volatile and at times irrational in the short term, this short term analysis could hurt your overall performance.
Some may claim that saying “long term investing works over the long term” is too axiomatic. But, historical analysis of the market proves that this statement is actually right, and that long term thinking is probably the best way to survive periods of bear market.
In case you are not convinced, look at the historical performance of the market following a bearish period. We have experienced 11 bearish markets since World War II, including the dot.com decline. The average market decline was 20.8% (it should be noted that all the following statistics represent the S&P 500 index results). But, one month after the market reached the bottom, the average recovery was 10.6%. After three months, the average recovery was 14.7%; six months later, the average recovery was 23.1%. Ultimately investors who held on and did not sell their positions 12 months after the bottom were rewarded with an average recovery of 34.8%!
Of-course, past performance is no guarantee for future results. Nevertheless, experience strongly suggests that in bear markets, patience pays. So, in order to smoothly pass the bearish period and succeed in your investing goals, consider the following four fundamental principles.
1. Own quality.
Great companies, whether they are growth, value or dividends paying companies, are the best companies to hold in your portfolio. The stocks of these companies could be affected in the short run from the massive selling of irrational investors during the bearish period; however, their financial strength would probably stay stable. Most of them would even continue to grow and develop. As time passes and the bearish period ends, the stock price would quickly catch the intrinsic (fair) value of the company, and the price will go up. In any case, do not just buy great companies; buy the cheaper ones.
2. Buy cheap.
Not all stocks are declining in a bearish market. There are companies which were traded at discount to their fair value even before the bearish market has started. It is possible that some of these stocks will still lose additional value, but chances are that many of them would yield a positive return even during this period.
For example, stocks with lower multiples, such as Price to Earning ratio (P/E) or Price to Book ratio (P/B), sometimes tend to be cheaper. However, low multiple is not enough; you must compare the company’s multiple to the average multiple of its industry. Moreover, it is also better to compare the current multiple of the company to the historical values of the same multiple in the past. Good companies (such as the ones mentioned above) having lower multiples compared to historical values and to the industry average, have better prospects of becoming successful investments even during a bear market. In
Yalicoo’s competitions, you can identify many ideas for these kinds of stocks that other investors are holding, making your stock picking much easier.
3. Diversify your portfolio.
Use rational asset allocation when building your portfolio. As a rule of thumb (or at least- one of the rules), the percentage of stocks in your portfolio should not be higher than 100 minus your age in percentages (for example: if you are 40 years old, stocks holding percentage should not be higher than 60%). Higher percentage could be riskier considering the fact that you will eventually need to convert the stocks into cash. Thus, diverse your portfolio with a rational blend of assets – stocks, ETFs, bonds, and cash. Always keep some of your savings in cash or other risk-free securities that would be available for usage in the short term (for emergency situations or unpredictable events).
That’s not all. It is also recommended to diversify the stock portion of your portfolio as well. You never know in advance which sector would be the one to get hit in the future. Thus, choose stocks from different sectors, different regions around the globe (investing in the global marker is also a venue to consider), and also in different kind of stocks – growth, value, dividends etc. This will protect your portfolio from catching on fire even if few sectors or a specific region in the world suffer from a temporary recession or economical weakness.
4. Think for the long term.
In the short term any thing can happen. The market could be growing, slowing or going through recession. However, history demonstrates that remarkable returns can be achieved by patiently holding on to your assets for longer periods. In the short term there could be a large spread between a company’s intrinsic value to its stock price. However, in the long term these two values usually correlate and become much closer to one another. Therefore, treat your holdings as long term saving plan and do not let the short term market fluctuation affect your portfolio composition and decisions.
If you think in longer time frames, the bearish periods would look like tiny bumps along the way and you would have greater chances of realizing
higher returns in the long run.
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