How to Make the Most of a Down Market
If Wall Street’s got you queasy, here are five things you can do to help make sure you’ll be OK."
You may never learn to love bear markets, but you can learn how to make them more bearable. A bear market rips your portfolio for at least a 20% loss. (Smaller downturns of at least 10%, even the 19.8% price drop in the fourth quarter of 2018, are corrections.) Since World War II, the average bear market has clawed 33% from Standard & Poor’s 500-stock index and lasted 14 months.
It typically takes 25 months to get back to the level where the bear market started. The worst bear market in the period was the 2007–09 bear, which sacked the S&P 500 for a 57% loss in price alone (not including dividends). Investors had to wait 49 months to get back to even. Like economic recessions, bear markets are mostly recognized in hindsight. With the bull market in its 11th year, now is a good time to prepare.
Make a shopping list. Bear markets give you a chance to buy stocks on the cheap. Let’s say you have money to invest but think the market is on the expensive side. The S&P 500 recently traded at roughly 17 times projected earnings of nearly $172 a share for the next four quarters for the companies in the index. That’s above the 10-year average P/E of 14.8, according to FactSet Research. If the market were to suffer the average bear market loss of 33%, then the P/E on the S&P 500 would drop to a bargain-basement level of less than 12 times earnings.
If you invest for income, buy high-quality dividend stocks when their yields hit 4% or better, says Sam Stovall, chief investment strategist for CFRA. (Yields rise when prices fall.) Of the stocks in the S&P 500 that pay a dividend (not all do), the average yield is 2.45%. Income-seeking investors can begin their search with the Dividend Aristocrats, stocks which have increased dividends every year for 25 years. Or consider S&P 500 Dividend Aristocrats ETF (symbol NOBL, $71), which invests in all the Aristocrats and yields 2%.
Dollar-cost average—with a twist. Most people dollar-cost average through their workplace retirement plans. When you invest a set amount each paycheck, you buy more shares as the market falls, lowering your average cost over time.
Take even more advantage of bargains by boosting your contribution rate—say, by a percentage point when the market is down 20% from its most recent high, and another percentage point every time the market posts an additional 10% loss. If you were contributing 6% of your salary before a bear market, you’d increase your contribution to 7% when the stock market is down 20% and 8% after it falls 30%.
Rebalance. Consider rebalancing your portfolio when the market is down 20% or more. When you rebalance, you reset your portfolio to your preferred asset allocation. Say you’d decided to keep 60% of your portfolio in stocks and 40% in bonds, but thanks to a bear market, you now have 50% in bonds and 50% in stocks. In this case you’d move money from bonds into your stocks until you got back to your 60%-40% mix. You’ll be selling your winning investments—bonds—when they are high, and buying stocks when prices are low.
Know your risk tolerance. Most people feel pretty comfortable with risk—when the stock market is rising. When the market is falling, however, it’s a different matter. It’s best to take a hard look at your risk tolerance before the market falls, not after. Bear in mind, for instance, that you’ll need a 50% gain to erase a 33% loss. Do you have the extra time to make up for that loss, or would it force you to postpone important goals, such as retirement?
Ignore the noise. The market often exhibits short-termism, says Rob Arnott, chairman of the board of Research Affiliates. But you should be a long-term investor. When the market is in a tizzy about this or that, ask yourself: Will what is happening now matter in 10 years? If not, learn to ignore it. For example, we most likely won’t be talking about Brexit in 10 years. Instead, focus on things that will matter in the next decade, such as the likelihood that corporate earnings will be higher in 2029 than they are now.