6 months ago • 5:13 mins
Making a fortune when markets are skyrocketing is the easy part; the hard part is holding onto that fortune when a bear market rears its ugly head. And with valuations at all-time highs and the US Federal Reserve ready to raise interest rates, we may well be approaching that point. So if you want to be prepared, here are a few tips on what you should and shouldn’t be doing with your portfolio.
Here’s the thing: unless you’re very experienced or urgently need a hedge, you should probably stay away from shorting stocks. And if you’re planning to short stocks to make up for losses you suffered on the long side, you should definitely tape your arms to your chair and avoid hitting the sell button at all costs.
No, really: making money from shorts might be the biggest challenge faced by retail investors and pros alike. That’s because price action is very different on the downside than on the upside (there’s a well-worn adage that “Stock prices go up the stairs, but come down in the elevator”), and because you’re likely to get burned every time there’s a “fake rally”. Take it from my hard-worn experience: you don’t want to have to cover your shorts in response to sharply rising prices, only for prices to suddenly nose-dive again.
In a bear market, not every asset goes down. In fact, defensive assets like government bonds and gold have historically provided attractive returns in environments where stocks went south.
It’s true that some of those assets can be questioned amid today’s backdrop, but it’s highly unlikely that every asset will go down at the same time – and certainly not for a prolonged period. If, for example, the Fed raises rates sharply, bonds would be a poor hedge to your stocks. Gold, however, should do well in that situation. Likewise, if gold takes a beating due to lower inflationary pressures, your bonds should fly.
Making sure you have a portfolio that is diversified across different risk scenarios won’t just go a long way toward mitigating your losses in a bear market, it’ll also reduce the need to try to predict what macroeconomic environment will come next. That’s why the world’s biggest hedge fund Bridgewater swears by an “all-weather” portfolio that theoretically performs in any macro backdrop (more on how you can build your own here).
You could cash out and wait for the storm to pass, sure, but then how will you know when to buy back into the markets? It’s much, much easier said than done.
So you shouldn’t try. Instead, a simple yet powerful strategy is to spread out your investment over time. Chipping in a regular amount at regular intervals (a.k.a. dollar cost averaging) is a great way to buy more of an asset when prices are low and less when they’re high, effectively reducing your average entry price. This mechanical approach also has a few other advantages: it guarantees you’re invested when the market rallies again, it reduces the risk you let greed and fear drive you, and it’s a plan so straightforward that you’ll eliminate one big source of worry.
Buy-and-hold might be the best way of protecting yourself during a bear market, but those who want to actually profit will need to switch from a long-term, passive approach to a shorter-term, active approach.
Active traders are always looking for their next quick hit. From a currency pair that’s overshot its fundamentals to a momentum strategy that allocates to the strongest assets, these traders are constantly trying to identify the next market dislocation they could profit from. But it’s not easy: you have to have an edge, a clearly defined investment process, and a lot of time on your hands to analyze markets and implement your strategies.
If you’re willing to dip your toes into more tactical approaches, you should have a look at the Insights my colleague Reda wrote about tactical asset allocation (part 1, part 2, and part 3). Professional trader Brent Donnelly’s book The Art of Currency Trading is also a great read on what it takes to be successful in shorter-term trading, and should be required for anyone willing to be more tactical – whatever asset class they trade.
It’s extremely hard to know where we are in an economic cycle when we’re in the middle of it, but the market’s overall greed and fear generally provides a pretty good clue.
In the late stage of bull cycles and early stage of bear markets, greed tends to drive markets. In other words, investors are buying riskier assets (like tech stocks, junk bonds, and crypto) and investing in ever-more complex financial products (like SPACs). In times like these, it’s better to play it more defensive – by having a more diversified portfolio, for example, or by having a higher allocation to defensive sectors like consumer staples stocks or utilities. I’d argue that’s where we are currently.
But after stock prices undergo a large drop (historically 20% and more) and the media is overwhelmingly bearish, investors tend to get spooked and sell indiscriminately. This is when you have to start being greedy, adding risk to your portfolio by rotating from defensive sectors and assets to more cyclical, economically sensitive ones.
A decline in the overall stock market doesn’t mean you can’t make money investing in stocks.
One way to make money in bear markets is to implement “relative value” investments, where you go long an asset and short another. Such long-short trades are deemed “absolute returns” because they don’t depend on the overall market direction: they depend on how one asset fares relative to another.
For instance, both consumer discretionary and consumer staples stocks go down when the overall market falls, but consumer staples – which are more defensive – generally fall by less than consumer discretionary. So by going long staples and short discretionaries, your returns are driven by the outperformance of one sector over another – not by the general market direction.
You can also bet on the relative performance of different countries or regions (European stocks outperforming US ones, for example), market capitalizations (shorting riskier small-cap stocks versus buying more reliable large-cap ones), valuation characteristics (buy value stocks and short growth stocks) or quality attributes (buy higher-quality stocks, sell junk stocks).
I know I’ve hammered this before, but here it is again: if you don’t have a plan for when markets hit bear market territory, creating one should be a top priority. Even if you’re a die-hard buy-and-hold investor, you might struggle not to do anything when markets are down 70% and every news outlet is announcing the end of the global economy as we know it.
Your plan could be as simple as sticking a “I will never, ever, under any circumstances sell” Post-It note to your screen, but that’s still a plan. And thinking about what you will or won’t do ahead of time might be the difference between busting your portfolio for good, and putting it in the best position to capitalize on the eventual recovery.
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