A bear market is never a pleasant environment to be in, especially if you are an investor with considerable exposure to the market. The reality is that if you are looking to achieve modest levels of growth in your portfolio, you will likely be exposed to market risk.
One famous bear market investor is Michael Burry, who bet against the housing market in 2007 and 2008 and made a fortune for his fund.
Although it can be profitable in the short term or for trading purposes, shorting the market is almost never a viable long-term strategy. This is because the market always trends up over longer periods of time.
If you are looking for how to invest in a bear market, there are four approaches to take that will improve your chances of investment success:
- Reduce equity risk by owning safer companies
- Diversify into alternatives, especially hedge fund strategies
- Increase your cash allocation early on
- Dollar-cost average when purchasing new investments
Can you Still Make Money in a Bear Market?
A professionally-constructed portfolio is not generally built to earn positive returns in all market conditions. Gaining returns from the market over the long term usually requires sustaining losses during periods of economic stress.
In a generic bear market, very few strategies will allow you to make money.
The first strategy that will allow you to make money is short selling assets that are dropping in value. This strategy will usually require a margin account, and is not recommended as an approach over the longer term.
A second strategy is to invest in the very few rare assets that generally increase in value throughout bear markets. Some examples include:
- The US dollar as a currency, versus other currencies
- Long-term government bonds (assuming interest rates are falling)
For most investors, the best approach to investing in a bear market is to control your exposures.
We will cover how to invest in a bear market below and discuss each approach in more detail.
How to Invest in a Bear Market
Approach 1: Reducing Equity Risk by Owning Safer Companies
Across the broad universe of stocks that you can invest in, there are riskier stocks and safer stocks.
Characteristics of a riskier stock typically include:
- The company operates in a newer, futuristic sector
- The firm does not have any profits or positive cash flows
- The stock trades at very richly-valued price multiples
Characteristics of a relatively safer stock include:
- The company operates in a mature industry
- The firm has steady profits, positive cash flows, and generally pays a consistent dividend
- The stock trades at cheap multiples
Putting Cash to Work
If you are holding a lot of cash in your accounts, a bear market is a great opportunity to buy shares in high-quality companies. The shares of these companies have likely fallen in value because of the bear market, and are now cheaper to purchase than before.
Although it is difficult to time the market, keep in mind that volatility always subsides over a longer period of time.
The stock market is generally viewed as a leading indicator and recoveries from bear markets tend to be quick.
A critical concept to understand is that of dollar-cost averaging, which we will explain later on.
Switching from Riskier Stocks to Safer Stocks
If you would like to de-risk your portfolio for any future volatility, a bear market can be a good time to do so.
Selling riskier stocks to buy safer stocks can have substantial tax consequences, especially in non-registered accounts. Before selling any positions in your portfolio, make sure to consider the tax implications that the sale would have.
Approach 2: Diversifying into Alternatives
Alternatives, especially some hedge fund strategies, can be great portfolio diversifiers to help protect against portfolio drops in bear markets.
Some key strategies to consider during a bear market fall under the hedge fund or liquid alternative universe.
Alternative Strategy #1: Market-Neutral Funds
A market-neutral fund is a hedge fund approach that aims for positive returns through all market conditions. This is usually achieved through the portfolio manager’s skill in selecting long-short investment pairs.
Market-neutral funds are sometimes available as liquid alternatives, meaning that they are available as a standard ETF. Their returns tend to be fairly modest and they usually have very low volatility.
Market-neutral fund returns are almost entirely dependent on the skill level of the fund’s portfolio manager.
Alternative Strategy #2: Dedicated Short-Bias Funds
A dedicated short-bias fund will usually have a significant amount of exposure to short positions. These funds are not always 100% focused on short selling and will almost always have some long exposure to stocks.
Since most asset classes are falling in price during a bear market, dedicated short-bias hedge fund strategies shine during this period of time.
Dedicated short-bias funds also depend heavily on the skill level of the portfolio manager.
Alternative Strategy #3: Long-Short Funds
A last great alternative strategy to consider adding to your portfolio is a long-short strategy. These funds, while not overly focused on short selling, do have a portion of their portfolios in short positions.
The short positions will likely help with relative performance during a bear market. The performance of a long-short fund is again very dependent on the skill level of the portfolio manager.
Approach 3: Increasing Cash Allocation Early
If you are likely enough to detect a bear market early on, switching a portion of your portfolio to cash can also be a great way to preserve capital in the short term.
This does not mean selling your entire portfolio and moving entirely to cash. A well-constructed portfolio should have a cash allocation of several percent over time. This allocation can be increased during the onset of a bear market.
Always take great care when liquidating positions, especially in a non-registered account. The tax implications involved with selling a large number of winning positions can set you up for a massive tax bill in the year of the sale.
As we have mentioned before, markets tend to recover from bear markets extremely rapidly. A move to cash should generally only be a short-term solution, in order to be invested once assets recover from the bear market.
Approach 4: Dollar-Cost Averaging
Dollar-cost averaging is an excellent strategy for when markets are volatile or trending downward.
Dollar-cost averaging (DCA) means spreading out your purchases over time, as opposed to purchasing an investment entirely at one point.
An example of DCA would be an investment of $1,000 each month into a particular stock for a year. The alternative would be to invest $12,000 in the stock today.
DCA allows you to benefit from volatility, especially in falling markets. If stocks are dropping over several months, a monthly DCA plan will allow you to buy shares at lower prices over time.
Dollar-cost averaging into an investment over the course of a bear market should allow you to have a much lower average cost per share.
If you are faced with a bear market, using all four strategies can help with preserving capital and reducing volatility over the course of the market drop.
Bear markets do come and go over time so don’t be surprised if you are caught in one after a long period of great market returns.
The stock market always fluctuates and experiences volatility, but has risen consistently over longer periods of time.
We do not advise short-selling the overall market, as this can lead to large losses if the market recovers rapidly. Instead, focus on minimizing losses or optimizing your portfolio.
Transitioning to safer equities can reduce future volatility as a bear market continues over time.
Diversifying into alternatives, especially some key hedge fund strategies can provide your portfolio with an uncorrelated source of growth. You may even get a positive return when the broad market is down.
Increasing your cash allocation can also help to reduce short-term losses if downward pressure continues on markets. Market recoveries are usually very explosive in nature, so it is not in your best interest to be in cash for too long.
Lastly, dollar-cost averaging will allow you to invest throughout a bear market at lower and lower prices (if the market continues falling). It is an excellent way to bring down your average cost per share in a down-trending market.
Remember to always consider your objectives, risk tolerance, and constraints as you invest.
During a bear market or tough economic times, these elements may rapidly change. Never allow your emotions to dictate when to buy or sell any investment.