STOCKS HAVE YET to close 20% below their Feb. 19 all-time high, so technically the U.S. market hasn’t entered bear market territory. Still, after this morning’s sharp drop, the S&P 500 is 17% below its peak.
If this decline does indeed become a bear market, how can you prepare yourself? A bear market can be an emotionally gut-wrenching time—one that leaves you feeling vulnerable and helpless. But there are steps you can take to limit the damage to your investment portfolio. In particular, here are four lessons I’ve learned from previous bear markets:
1. Favor high-quality bonds. All bonds do not perform the same in a bear market. In fact, some bond funds can be as volatile as stocks. During the 2007-09 bear market, I owned two bond funds: Vanguard Total Bond Market Index Fund and Vanguard High-Yield Corporate Fund. According to Vanguard Group’s site, the high-yield fund invests in “medium- and lower-quality corporate bonds, often referred to as ‘junk bonds’.”
In 2008, the total bond fund gained 5.15%, while the high-yield fund tumbled 21.29%. During bad economic times, people prefer better quality bonds, because there’s a higher likelihood that they’ll get paid. The total bond fund invests a significant portion of its assets in U.S. government debt, probably the safest investment to own during depressed economic times. Meanwhile, junk bonds are lower quality and hence at greater risk of defaulting on their interest payments.
Result: Short- and intermediate-term government bonds are good choices in a bear market. Although they may not provide as much income as other bonds, they offer the stability your portfolio needs in turbulent times.
2. Avoid individual stocks and sector funds. Why? You want to be confident all your holdings are viable long-term investments, so they’ll bounce back when the market recovers.
Even mutual funds can go out of business in tough times. Merrill Lynch launched its Internet Strategies Fund in March 2000, just as the tech bubble was bursting. The fund lost a shocking 70% and went out of business in just over a year. According to U.S. News & World Report, “While Internet Strategies had what was perhaps the industry’s most embarrassing timing, it was hardly the only fund to close its doors in the wake of the bubble.”
Result: For your portfolio’s core holdings, stick with broad-based index funds. When you invest in a U.S. total stock market index fund, you’re investing in the total U.S. economy. Not all U.S. companies will survive an economic downturn, but we know the U.S. economy will.
3. Cash is king in a bear market. You never want to lock in your investment losses by selling stocks at a market bottom. You need to have enough cash to ride out the downturn and give your stock market investments a chance to recover.
According to CBS News, “On average, bear markets have lasted 14 months in the period since World War II, while market corrections have lasted an average of five months. The S&P 500 index has fallen an average of 33% during bear markets in that time. The biggest decline since 1945 occurred in the 2007-2009 bear market,” when the S&P 500 fell 57%.
Result: If you’re living off your investment portfolio, you should have a cash reserve equal to at least two to three years of living expenses, so you can withstand the onslaught of a bear market and avoid the need to sell stocks. On top of that, you’ll likely want a substantial allocation to bonds.
4. Stay the course. You need to have the courage to stick with your investments in difficult times. Making radical changes to your portfolio during a bear market is usually a losing proposition.
Result: Having the right mix of stocks and more conservative investments should give you the fortitude to stay the course during a bear market. Not sure you have the necessary courage? Consider hiring a fee-only financial advisor to help coach you through the decline.
Dennis Friedman retired from Boeing Satellite Systems after a 30-year career in manufacturing. Born in Ohio, Dennis is a California transplant with a bachelor’s degree in history and an MBA. A self-described “humble investor,” he likes reading historical novels and about personal finance. His previous articles include Time to Shrug, Small Is Beautiful and On My Mind. Follow Dennis on Twitter @DMFrie.