When stocks go down, investors may become concerned. In a bear market, concern can morph into panic. While you should take stock market downturns seriously, there’s no need to freak out. You can both navigate downside and implement straightforward strategies to benefit from it.
The U.S. Securities and Exchange Commission (SEC) describes a bear market in both a broad and specific way:
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.
It’s nice to know exactly what a bear market is, but it’s even more important to have strategies you can use year-round, including when stock prices drop, no matter by how much or for how long. Here’s what to do with a stock market that doesn’t only go up.
What Happens to Stocks in a Bear Market?
During a bear market, stocks will have dropped by 20% or more from their highs, as measured by broad indices such as the S&P 500. Fidelity Investments analyzed every U.S. bear market since 1929 and found that stocks recover by an average of 47% in the year after hitting lows.
Consider the bear market of September 2018: After a 20% decline and three-month-long bear market, stocks returned 37% in the following year.
Of course, this means you can lose money in a bear market—if you sell. However, if you stay the course, history shows that these losses are temporary. In fact, doubling down—buying more stock when prices are low—might actually enhance your long-term returns.
Bear Market Investing Strategies
You can put the following relatively conservative strategies to work in any market; however, they all function defensively, to some degree, in a bear market.
Dollar Cost Averaging
When you dollar cost average into a stock, you make incremental purchases over time, such as biweekly or monthly, as opposed to investing your cash all at once in a lump sum. The SEC suggests this strategy, particularly in volatile markets. Dollar cost averaging allows you to buy more shares of a stock when prices are low and fewer when they’re high, thereby striking a cost-basis balance between upside and downside.
Dividend Growth Investing
Dividend growth investors buy dividend stocks with a history of dividend increases. This strategy suits a bear market for two primary reasons:
- You can reinvest dividends into new shares of stock: As with dollar cost averaging, these dividend reinvestments purchase more shares when stock prices are low.
- Dividends generate a stream of income associated with your long stock positions: Dividend investors tend to reinvest that income or collect it as cash. In either case, the income stream takes some of the focus off stock price appreciation. In others words, you don’t own a stock only because you intend to sell it for a profit; you own it for the dividend yield it generates, which, generally speaking, increases as the stock price decreases.
During a bear market, investors tend to punish stocks across the board or close to it. When this happens, you can find bargains in individual stocks or sectors. For example, if airlines or automakers took an especially hard hit in a bear market, you might buy a basket of these stocks while they’re down in anticipation of the aforementioned historically supported positive reversal.
Value investors look for stocks trading below their perceived value. This tends to happen somewhat broadly during bear markets.
Riskier Ways To Handle a Bear Market
More advanced investors might consider riskier bear market strategies. But beware: These are nuanced strategies. They’re risky. Only consider them if you have a true understanding of how to execute each strategy.
When you sell a stock short, you’re making a bet it will go down. To do this, you generally borrow shares of the stock you want to short from your broker, sell them, then buy them back, ideally at a lower price. This is an advanced strategy that often requires the use of trading on margin.
Shorting a stock is an advanced investing strategy that may not be suitable for new or inexperienced investors.
Puts and Other Derivatives
You can play market downside using options. Options may be best for intermediate or advanced investors.
This said, the most straightforward options strategy is to buy puts in a bear market. When you buy a put, you’re betting a stock or index will go down. Let’s say a stock trades for $40. You can buy an out-of-the-money put with a strike price of $35. All things equal, you start to profit on the trade when the stock drops below $30 prior to the options expiration date.
Other more advanced options strategies exist, but it may be best to leave it at the most basic (yet still technically risky) put buying.
You can buy and sell inverse ETFs just like any other ETF; however, inverse ETFs go up when the index they track goes down. For example, if you buy an inverse ETF that tracks the S&P 500, you’re betting the S&P 500 will go down so that your investment goes up. However, it’s not always as simple as this. Many inverse ETFs are complex products with nuances that go beyond marketing, which can be difficult for investors, particularly beginners, to understand and deploy.
Assess Your Money Strategies, No Matter the Market
Before you even invest in stocks or aim to implement the strategies above, ensure that you have your personal finances in order.
Prior to buying stocks, fill an emergency fund with three months to one year of expenses. Keep a rainy day fund for things that come up that aren’t necessarily emergencies, such as a flat tire or minor home repair. The balances you keep in savings will vary based on your cash flow, overall spending habits, and comfort level.
Be sure to eliminate high-interest debt ahead of moving money into the market.
Ensure that you’re practically and emotionally comfortable with your personal finances prior to investing, particularly in a volatile market.
From here, consider what type of investor you are or want to be. How comfortable are you with risk? Can you stomach and ride out on-paper losses when the market drops, crashes, or, quite possibly, turns bearish?
No matter your appetite for risk, it makes sense to consider defensive investing strategies. Defensive investing might sound boring, but these approaches exist, in part, for the express purpose of thriving, not merely surviving, during stock market downside.
The Bottom Line
Bear markets can be scary, but there’s no better strategy than being prepared. The best strategies to combat market downside do not have to be complicated. In fact, they can be straightforward, defensive strategies, such as dollar cost averaging or dividend growth investing, relevant in all market conditions, bearish or bullish.
As with any investing approach, start with the basics. Keep it simple, and go from there. If you consider more advanced strategies, proceed with caution. Making the wrong moves with trading and investing vehicles such as options or inverse ETFs can trigger quick losses that might not reverse. On the other hand, if you’re patient, history shows that bear markets, sooner or later, turn positive, if not outright bullish again.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.