Current market volatility has many investors wondering how to minimize losses and find new opportunities. But whether you're worrying over your IRA or alternative investments, there are several strategies you can implement to survive a market downturn. So, to navigate the current market conditions with ease, here are some ways to keep calm and invest on. A financial advisor can help you put together a financial plan that will keep you on the right path no matter the market conditions.
What Causes a Stock Market Crash?
A bear market is more broadly defined as a 20% or more decline in a major stock index from a recent peak, regardless of how sharp or gradual that decline is. The bear market remains until stocks recover and surpass the previous peak, which can take months or years.
Most economies go through what is called the business cycle or the economic cycle. This existed before central banks, but central banks now play a major part in it as well. It's the wave-like nature of how economies grow and debt cycles develop.
On top of that, there's the herd-like psychology of the stock market, which tends to magnify the booms and busts of the business cycle.
2008 Global Financial Crisis
In 2008, banks and investment firms were over-exposed to mortgages granted to individuals with poor credit scores (known as subprime mortgages). While many institutions were not directly involved in the issuing of this debt, they invested in an array of these subprime mortgages.
When these subprime mortgages began to default, and the housing market collapsed, banks and investment firms were exposed to significant losses. This threatened the global financial system and made access to short term liquidity (the ease with which an asset, or security, can be converted into ready cash without affecting its market price – Opens in a new window) difficult, forcing governments and authorities to intervene with support packages to rescue financial institutions. Poor regulation and supervision of the financial sector contributed to the sharp market decline.
Out of major market events come major learnings
First, diversification is key. It is a basic principle to long term success and to weather volatility. It's important to ensure your investments are diversified. Nobody can predict the future, so a well-diversified portfolio is essential. Spreading your investments globally across a wide variety of asset classes, including equities and fixed income, can help reduce your risk.
Another widely agreed upon lesson – stick with your plan and stay invested.
The COVID-19 crash and rebound was the fastest bear market recovery in history which highlighted the importance of staying invested and not selling investments around traumatic market events. Those who continued to stay invested during the pandemic are reaping the tremendous returns from the recovery of the market.
Keep Your Fears in Check
There is an old saying on Wall Street: “The Dow climbs a wall of worry.” In other words, over time the Dow has continued to rise despite economic woes, terrorism, and countless other calamities. Investors should try to always separate their emotions from the investment decision-making process. What seems like a massive global catastrophe one day may be remembered as nothing more than a blip on the radar screen a few years down the road. Remember that fear is an emotion that can cloud rational judgement of a situation. Keep calm and carry on!
Accumulate With Dollar Cost Averaging
The most important thing to keep in mind during an economic slowdown is that it's normal for the stock market to have negative years—it's part of the business cycle. If you are a long-term investor (meaning a time horizon of 10+ years), one option is to take advantage of dollar-cost averaging (DCA). By purchasing shares regardless of price, you end up buying shares at a low price when the market is down. Over the long run, your cost will “average down,” leaving you with a better overall entry price for your shares.
During a bear market, the bears rule and the bulls don't stand a chance. There's an old saying that the best thing to do during a bear market is to play dead—it's the same protocol as if you met a real grizzly in the woods. Fighting back would be very dangerous. By staying calm and not making any sudden moves, you'll save yourself from becoming a bear's lunch. Playing dead in financial terms means putting a larger portion of your portfolio in money market securities, such as certificates of deposit (CDs), U.S. Treasury bills, and other instruments with high liquidity and short maturities.
Having a percentage of your portfolio spread among stocks, bonds, cash, and alternative assets is the core of diversification. How you slice up your portfolio depends on your risk tolerance, time horizon, goals, etc. Every investor's situation is different. A proper asset allocation strategy will allow you to avoid the potentially negative effects resulting from placing all your eggs in one basket.
Invest Only What You Can Afford to Lose
Investing is important, but so is eating and keeping a roof over your head. It's unwise to take short-term funds (i.e., money for the mortgage or groceries) and invest them in stocks. As a general rule, investors should not get involved in equities unless they have an investment horizon of at least five years, preferably longer, and they should never invest money that they can't afford to lose. Remember, bear markets, and even minor corrections, can be extremely destructive.
Look for Good Values
Bear markets can provide great opportunities for investors. The trick is to know what you are looking for. Beaten up, battered, underpriced: these are all descriptions of stocks during a bear market. Value investors such as Warren Buffett often view bear markets as buying opportunities because the valuations of good companies get hammered down along with the poor companies and sit at very attractive valuations. Buffett often builds up his position in some of his favorite stocks during less-than-cheery times in the market because he knows the market's nature is to punish even good companies by more than they deserve.
Take Stock in Defensive Industries
Defensive or non-cyclical stocks are securities that generally perform better than the overall market during bad times. These types of stocks provide a consistent dividend and stable earnings, regardless of the state of the overall market. Companies that produce household non-durables—such as toothpaste, shampoo, and shaving cream—are examples of defensive industries because people will still use these items in hard times.
There are ways to profit from falling prices. Short selling is one way to do so, borrowing shares in a company or ETF and selling them – hoping to buy them back at a lower price. Short selling requires margin accounts, and could cause harmful losses if markets rise and short positions are called in, squeezing prices even higher. Put options are another choice, which gain value as prices fall, and which guarantee some minimum price at which to sell a security, effectively establishing a floor for your losses if you are using it to hedge. You will need the ability to trade options in your brokerage account to buy puts.
Inverse exchange-traded funds (ETFs) also give investors a chance to profit from a decline in major indexes or benchmarks, such as the Nasdaq 100. When the major indexes go down, these funds go up, allowing you to profit while the rest of the market suffers. Unlike short selling or puts, these can be purchased easily from your brokerage account.
Why Is it a Good Idea to Keep Investing Through Bear Markets?
Over the long run, the stock market tends to go up and the economy grows. While bear markets may interrupt this otherwise bullish trend, these downturns always have ended and ultimately reversed, reaching new highs. By investing through bear markets, you can buy stocks when they are priced lower (“on-sale”) and accumulate stronger positions.
Most of the results come from getting a few major things right:
- Maintain a high savings rate, and live below your means during prosperous times. Always be prepared.
- Diversify your portfolio among several asset classes and geographic regions. This usually improves risk-adjusted returns.
- Re-balance your portfolio regularly, and don't follow the herd. Don't panic-sell stocks after a crash, or euphoria-buy stocks after a long bull market.
- Consider occasional active tactical moves to sidestep unusually large bubbles. This could mean, for example, trimming equity allocations during rare periods of extreme overvaluation.
Then there are some specific approaches, like using hedging strategies, focusing on dividend stocks, or employing timing models to try to optimize returns or reduce volatility. A focus on dividend growth stocks is good for most investors, while some of these other strategies are more advanced.
However, always be mindful of how these approaches affect fees and taxes, and consider what shortcomings they may have.
Remember, most professional active managers under-perform index funds net of fees. Trading too frequently, or being too active with your portfolio, is more likely to reduce returns than improve returns.
Overall, balance is key. Don't be a perma-bear, but be aware of the business cycle and things that could damage your wealth.