The best time to prepare your investments for a bear market is before one happens. Though it may seem absurd to be thinking of a bear market at a time when Wall Street seems to be reaching new highs every week, that’s actually the best time. Bear markets overwhelmingly start at market peaks, and rarely when the market is just drifting.
Though there is no way to completely avoid taking losses in a bear market – other than going 100% into cash – there are steps you can take that will minimize the damage.
Step 1: Stop Putting New Money Into Stocks
This step doesn’t even require any radical action on your part. You simply stop putting money into equities as a way of minimizing your risk going forward. Your existing stock positions will continue to participate in the rising market – for as long as it lasts.
Step 2: Build Up Your Cash Reserves
Not putting new money into stocks doesn’t mean that you should stop funding your investments. Quite the opposite. You should continue pouring as much money into your investment portfolio during a bear market as you would during a bull market. The only difference is what it is you put it into. And that should be cash.
Cash has enormous value in a bear market. It’s not just that you are holding an asset that is immune to stock market declines either. What is probably even more important is that cash enables you to build up capital so that you will have plenty of it when the bear market finally ends. At that point, you’ll need to reverse course, and become a buyer of stocks once again. The more cash that you have, the more bargains you’ll be able to buy.
Your cash reserves should be held in US Treasury bills, money market funds, or certificates of deposit. Emphasis needs to be on capital preservation at this point, and not on chasing the highest yields possible.
Step 3: Assess Your Non-Investment Capital Needs
This step actually has nothing to do with the bear market itself. Rather, you are assessing your financial situation apart from your investments. This means looking out over the next two or three years, and making a realistic estimate of how much capital you may need for non-investment purposes.
- Will you be buying a house in the next couple of years?
- Will you have one or more children going off to college?
- Do you have an ailing family member who may be in need of direct or financial assistance from you?
- Are you facing a potential medical issue that may require a substantial amount of cash?
These are just some of the potential cash needs you can have, so you’ll need to do some serious soul-searching here.
The point of this step is to make sure that you are giving priority to any personal needs that may need to be satisfied out of your investment portfolio. The last thing that you want to do during a bear market is to be forced to sell investments into a declining market. That will effectively lock in your losses forever. But knowing what those needs are, and raising cash in an orderly fashion, will keep you from making mistakes later.
Step 4: Sell Your Biggest Losers
If a stock or a fund has declined during one of the biggest bull markets in history, it’s very likely that it will do even worse in a bear market. The point is, if you’ve already taken losses on an investment, the last thing that you want to do is extend those losses in a general market decline.
Step 5: Sell Your Biggest Winners
Many stocks do so well during a bull market, that their price far outstrips their fundamental value. While that is a common situation in a bull market, these stocks can be punished especially severely during bear markets.
In bull markets, investors tend to go with the winners, often regardless of fundamental value. The stocks can also attract a large number of unsophisticated investors, who are simply getting on the bandwagon of the best performers. When stocks turn down in a major way, investors suddenly “rediscover” the importance of fundamental value.
If you have any sense that you’re holdings stocks that have gone past the realm of reasonable valuation, now may be an excellent time to sell them, and to lock in your gains.
Step 6: But Don’t Panic Sell
The one thing you never want to do – even in a bear market – is to panic sell out of your investments. This could involve a wholesale dumping of all of your equity positions. But even in a bear market, that is completely unnecessary, and very likely to be counterproductive.
Though common sense tells us that bear markets follow bull markets, there’s no way to know exactly when that will happen, or how serious it will be. If you get out of stocks completely, you could miss a sudden turn around. Or you could miss out on a long-term continuation of the present bull market.
Be sure to have a significant amount of your money invested in stocks, even during a bear market.
Step 7: Keep An Eye Out for Emerging Opportunities
Once a bear market hits, it will be time to begin searching for emerging opportunities. As much as anything else, bear markets represent a changing of the guard in stock market leadership. One of your tasks during a bear market will be to identify which companies and which sectors step up and fill the leadership roles in the future. If you can, the ride back up will be sweet when a new bull market arrives.
If you come to think of bear markets as the preparation phase for the next bull market, you’ll be on solid ground. The idea is to minimize your losses, and prepare yourself for the next move forward in the markets.