When the stock market falls for a prolonged period of time, usually losing the value of 20% or more over a period of at least two months, investors call this a "bear market." Investors measure the market's decline by looking at the percent decrease in the stock price of multiple market indexes, including the Dow Jones Industrial Average (DJIA) and Standard & Poor's 500 (S&P 500).
Investor pessimism causes an increased sell-off of stocks, which reinforces the downward direction of the market.
- A bear market is the inverse or opposite of a bull market, in which stock prices move upward.
- Stock prices can spiral downward in a bear market for a number of reasons, such as catastrophic events or a change in corporate profits.
- The value of your portfolio might plummet suddenly in a bear market, or it might gradually decrease over time.
- The flip side is that you can take advantage of a bear market by purchasing investments while prices are down.
What Drives a Bear Market?
A sustained decline in stock prices can happen for any number of reasons, such as investors panicking over economic news including:
- An unexpected or catastrophic event
- Declining corporate profits
- A correction from a previous bubble of stock overvaluation
- A financial crisis in one industry impacting other interdependent industries
- The anxious foreboding of investors with a herd mentality
A bear market experience can scare would-be investors away from investing; you never know when a bear market will materialize and it takes psychological and financial fortitude to ride out the storm. Ironically, this fear alone can sometimes keep a bear market alive.
A Downward Influence on Investments
Generally, a bear market will cause the securities you already own to drop in price, perhaps by a substantial degree. The decline in their value may be sudden, or it could deteriorate slowly over time, but the end result is the same: The value of your portfolio holdings drops.
During a bear market, some investors prefer to focus on two fundamental principles that allow for taking advantage of the current market situation. First, a bear market is only bad if you plan on selling your stock or need your money immediately.
Second, falling stock prices and depressed markets are friends of the long-term value investor. Value investing was first developed at Columbia Business School by two professors, Benjamin Graham and David Dodd. Value investing was later popularized by the successful investor Warren Buffett.
As a value investor, you typically invest long-term with the intent to hold your shares for decades. A bear market creates a great opportunity to accelerate your returns over longer periods. This may seem counterintuitive. But with lowered stock prices, you can make periodic, fixed-amount investments over time in stock and bring down the average cost basis of your holdings and shorten your portfolio's recovery period once the bear market eases up.
This approach is also known as "dollar-cost averaging." You'll end up buying more shares when the price is down and fewer shares when the price moves up.
If you own dividend-paying stocks, reinvesting those dividends acts as a "return accelerator." The reinvested dividends reduce the cost basis of your portfolio as a whole so the quoted market value needs to increase by a smaller degree to reach break-even than your investment's original cost.
Making Lemonade out of Lemons
"Value investing" entails choosing stocks based on the underlying company's operational quality and ability to generate solid earnings over time. These company stocks make good long-term holds and will likely still have stable earnings 10 or 20 years down the road.
Learn to separate the stock price from the underlying business, as they often have very little to do with each other over the short-term.
Even if the market doesn't currently recognize a company's worth and undervalues its stock, if the company continues to make money as an operating business with solid financial and other characteristics, this says more about the intrinsic value, or essential nature of the company, than that reflected in its current share price.
The Bottom Line
Some investing experts believe the market is not perfectly efficient over periods of less than many years. So they see falling stock markets like a clearance sale at their favorite store; they load up on carefully researched stocks while they can because history has borne out that prices will eventually return to more reasonable levels, provided the company earnings materialize.