Wednesday, July 23, 2008

My Strategies for Weathering a Bear Market

Bear markets are painful experiences. Having been an investor in 8 of the last 10 bear markets, I can personally attest to the pain.

Here are some strategies I use to minimize the pain of a bear market:
  1. Own some boring, safe stuff. CDs and bonds, when held to maturity, do not lose money money in a bear market. And they continue to grow one's portfolio at the rate of interest payments. Cash also doesn't decline in a bear market.

    A common argument against CDs and bonds is that they don't keep up with inflation. My response is "neither does a negative return on stocks." I do agree that being 100% cash, CDs and bonds does poorly against inflation. However, having 10, 20 or even 40% invested in CDs, bonds or money market funds can be a good hedge when the market goes down.

    For example, my trading account is 42% CDs/Bonds, 49% money market, and 9% stocks. It is up 1.3% for the year. On the other hand, our managed accounts, which are 97% stock and 3% money market, are down 11.2% year to date.

  2. Own mostly quality companies and avoid poor performers. While affecting all stocks, bear markets seem to devastate poor performing companies. Strong companies, (e.g. GE or P&G) tend to survive bear markets. Marginal companies often go out of business or are sold at distress sale prices, e.g.

    In the 2002 bear market, I made the mistake of buying stocks in marginal companies as the market was declining. Some of the stocks kept going down, never recovered, and resulted in losses for my investment.

  3. Hedge. No one can predict the short term direction of the market with 100% accuracy. Therefore, I like to take small positions opposite to my expectation, to offset some of the losses. For example, our managed accounts are 97% invested in diversified portfolio of stocks, since I expect the market to be up in the long term. However, I currently have mostly CDs, bonds and cash in my trading account and will take some short positions, in case the current market advance is only a bear market rally.

    Another way I hedge is to take some profits with a stock that has risen significantly, selling 20 to 50%, and sometimes 100%, of a position to lock in some gains. I recently did this with Potash and Google.

  4. Be Patient. Historically, bear markets have always bottomed and the market then begins the next phase of a bull market. The length of a bear market averages a year in duration, but typically is less than two years and can be as short as a few months.

    By owning quality stocks and having sufficient cash, I believe I can wait out the bear market and participate in the next major bull market.

Of course, there are no guarantees. The magnitude of the current financial and economic crises may cause the bear marekt to last longer or cause more quality companies to go out of business. However, I am still betting on history and expect that this 10 month old bear market will bottom within the next year.

Disclosure: At the time of publication, I own GE, P&G, Potash and Google.

For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

This is not financial or investment advice. Please consult a professional advisor.

Copyright © 2008 Achievement Catalyst, LLC

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