What is the bear market?
A bear market is defined as a prolonged time when security prices decline by 20 percent or more. When the decline continues for more than 2 months, it is said to be the entry into a bear market. A bear market is marked by a period of negative returns. Market sentiments are pessimistic, leading to more stock sell-offs that further weigh down the market. The decline in stock prices can be caused by several factors such as panic selling by investors triggered by an economic crisis such as an unexpected catastrophic event, a financial crisis in one sector, market correction, and decline in corporate profits. It takes courage to ride the storm, and the bear market can be difficult on both new and seasoned investors. The best approach to a bear market would depend on the investors’ time horizon, investment objectives, and risk tolerance. While most fear bear markets, it can be the best opportunity to grow your portfolio and prepare the groundwork for long-term wealth building.
Understanding the Phases of a Bear Market
Bear markets are most often characterized by four distinct phases which are as follows.
Phase one is made up of high prices interspersed with investor sentiment being high. However, as this phases wanes out and reaches the end of its course investors begin to exit markets such that they can take in their profits.
Phase two views stock prices beginning to experience sharp falls, drops occur in trading activity and corporate profits begin to decline. Moreover, economic indicators which might have previously been positive begin to fall below the average. Some investors might begin to worry or panic while the investor sentiment begins to decline. This phase of time is known as capitulation.
Phase three occurs when speculators begin to enter the market owing to which some prices begin to rise along with the volume of trades carried out.
Phase four serves as the final phase and it witnesses prices continuing to decline, however this decline occurs at a slow pace. The low prices and positive news begin to capture the interest of investors once again as a result of which bear markets pave the way for bull markets to commence.
What to do in a bear market?
Severe bear markets may wreak havoc in your finances. Economic downturns can lead to salary cuts, reductions, and delay in payments. Before you delve into investing in a bear market, it is better to arm yourself first for a sputtering economy. Create a cushion and build a contingency fund that covers expenses for 6 months. This will save you during eventualities and prevent you from using your retirement savings.
Bear markets are also a good time to reassess your risk appetite. Some investors wait to ride out the bear market before investing. When the market fully recovers, investors often realise that they have missed the bus. The longer you wait, the further you fall behind. So make a staggered entry into the market but ensure you have enough cash in hand.
To make informed decisions, it is essential to have a financial plan in place. Without a plan, you are likely to make rash decisions during market upheavals.
Short Selling During a Bear Market
Investors are capable of accruing gains during a bear market by taking advantage of short selling. This strategy requires the sale of borrowed shares which are then bought back at lower prices. This strategy is extremely risky and is capable of incurring major losses in the event that events don’t transpire as planned. Short sellers are required to borrow shares from a broker prior to placing a short sell order. The profit and loss acquired by a short seller amounts to the difference that exists between the price at which the aforementioned shares were sold and then bought back and is known as “covered”.
Inverse ETFs and Puts During Bear Markets
With the aid of a Put option, investors and traders alike have the freedom without being tied down with the onus of selling a specific stock at a specified price on or prior to a specified date. Put options are made use of in order to speculate the falling prices of stocks and hedge against these falling prices such that long-only portfolios can be protected. When bear markets aren’t in existence purchasing puts is ordinarily safer than engaging in the aforementioned short selling.
Additionally, inverse ETFs can be employed in order to speculate or safeguard portfolios. Inverse ETFs function by changing values in the opposite direction of the index they follow.
Hold tight – If you believe in any company, then hold on no matter how steeply its stock price falls. You can consider selling if you need cash; you should also reassess your portfolio to check if trading in the company’s shares is prudent. It is better not to jeopardise your goals by liquidating long-term investment.
Buy stocks – During a bear run, the stock price of all companies fall. It is considered the best time to invest and buy shares. However, you should buy stocks of good companies which will rise in the future. Rebalance your portfolio and shift focus from growth stocks to value stocks.
Take a long-term approach – It is unlikely that the stocks you buy will yield returns within a year as it is difficult to predict how long the bear market will last. Hence take a long-term approach and buy stocks that you will hold for a longer period.
Buy dividend stocks – Bear markets are a good time to net companies with a history of high paying dividends. Dividends are a good way of generating a steady income. It will also allow you to reinvest the money you earn through dividends. However, do not ignore the high growth companies by looking only at dividend stock. When prices drop, it is the best time to buy high-growth shares that you have always been eyeing.
Diversify your portfolio – While bear markets are the best time to buy stocks, it can also be a good opportunity to diversify your portfolio and buy bonds. Bonds are less volatile and will give you a regular cash flow that you can reinvest. Bonds are fixed assets that reduce the amount of risk in your retirement portfolio. Addition of such assets that are not dependent on the market’s rise and fall can increase returns.
Timing the market – most investors flee the market and exit their investments during the bear market. Market volatility is a fact and while the drop creates a panic among investors, timing the market is a fool’s errand. The best move during the bear market is to ride through the storm.
Bear runs do not last forever. Hence being patient with your investments will win the day. Do not be in a hurry to sell your stocks. Keep monitoring the growth of companies and hold shares for a longer time horizon. If you are a new investor, it is a good time to enter the market. But make sure you invest in good stocks.