Bear Market Investing

The investment world has suffered bear markets before, and will no doubt experience them in the future. Is a down market a valid reason to eschew investing? Not at all, especially when there are profitable investment strategies that will help protect your assets against serious losses, and may even guarantee reasonable growth.

BEAR MARKETS DO END

Bear markets don't last forever. When we look back at some notable bear markets, we find the following market recovery periods:

June 1949: Six months after this date, the market had recovered 54% of its loss, and in 12 months it had recovered 100% of the loss.

October 1966: Six months after this date, the market had recovered 78% of its loss, and in 12 months it was 115% higher than in October 1966.

August 1982: Six months after this date, the market had increased 119%, and in 12 months it was 157% higher than in August 1982.

October 1990: Six months after this date, the market was 112% higher. Twelve months later it was 117% higher than October 1990.

Here is another example of the market's resiliency: On October 19, 1997, the Dow Jones Industrial Average (DJIA) lost 508 points in one day. Yet three months later, it had recovered all of the loss. That recovery was the precursor to a strong, three-year bull market that moved the Dow to an unprecedented robust gain, carrying it to 11,000. Before the next bear market began in the year 2000, the DJIA had soared to a record high of 11,500.

According to some technical financial indicators, the DJIA may be set to resume its bullish march. However, what can we do in the meantime?

SAFETY PRINCIPLES

Reinvested dividends regularly account for big quarterly contributions to investors' portfolios. These contributions serve to soften the effect of bear markets. Consider the following statistic: If you had invested your money in just the 30 stocks that make up the DJIA from 1998 through 2002, you'd be ahead by 5.84% on price alone. On the other hand, if you had reinvested all the dividends, you would be ahead by more than 15%.

A similar but less dramatic effect would show up if you were to invest in the Standard & Poor's 500 index. On price alone you would have lost an average of 9.3% per year for those four bear market years. However, if you had reinvested all the dividends, your loss would have been reduced to a mere 3%, compared to the general equity market's loss of 40% over the four years.

A general principle to protect your portfolio would involve reinvesting dividends regularly, as well as consistently adding new money to a well-diversified portfolio. This would put you ahead by more than 15% from 1999 to April 30, 2003, while the market was bearish.

Other general principles are designed to provide a safety net for your investment portfolio, the second of which is to create a well-diversified portfolio. It could consist of both stocks and mutual funds. Diversification has proved to be the most important of all risk-protection principles. Make sure your portfolio consists of stocks and/or funds that represent different sectors of the economy such as technology, pharmaceuticals, finance, leisure, precious metals, and retail establishments, or you will dilute the degree of diversification you should have.

The third principle is perhaps the most difficult to follow: You must be able to determine when to sell a nonprofitable investment. Having purchased a stock or mutual fund, you may be reluctant to dump it. You will tend to blame yourself for making a bad choice if the stock tanks. Thus, you continue to hold on, hoping the investment will come back and justify your choice, thereby removing your guilt. Instead, externalize these emotions. Realize you cannot control the market, and you are therefore not to blame for how it acts. Doing so will make it easier for you to sell off poor performers and cut your losses.

A fourth principle to follow during volatile bear markets is exactly the opposite of the sell principle. It answers the question, "Should you buy into a market when stock prices are falling and the general economy is a heartbeat away from bankruptcy?" The answer is yes. Surprising? Not so.

You may think it is foolish to throw good money after bad. You might think investing money during volatile bear markets is foolhardy and unjustifiable. However, a great many good stocks become much cheaper during bear markets. For example, AT&T shares lost almost 50% of their value during the recent bear market. Yet, no one can deny that AT&T is a very good company. Exxon-Mobil stock went from $44.50 to $29.75 recently. Bristol-Myers stock soared to a high of $41.50 and fell to a low of $19.40. PepsiCo went from a high of $53.50 to a low of $19.49 during the most recent bear market. These are all strong companies. What does this tell you? Now is the time to buy good stocks at bargain-basement prices.

The fifth method by which to protect your portfolio during volatile markets is to purchase only quality stocks. Quality heads the list of criteria that governs which stocks to buy and hold during bear markets. Don't speculate on the high flyers; those stocks are usually the first to suffer most during bear markets.

There are other excellent, less risky ways to move back into the stock market. For example, 401(K) and 403(b) accounts are painless ways to force yourself to return to the market. Open these types of accounts when you have the opportunity. Another excellent way is through DRIPs (dividend reinvestment plans). DRIP accounts permit you to invest in hundreds of excellent domestic and international companies by making a small initial investment as small as $250. You may then add to your DRIP stock accounts by reinvesting your dividends. Then, if you wish, you can make small periodic deposits of as little as $10 to $25 when you wish and as often as you wish.

Another device useful in protecting your investment against serious loss is the stop-loss order. A stop-loss order (or stop order) is the same as a sell order. This type of order authorizes your stockbroker to sell when a predetermined price is reached. When this happens, the stop order turns into a market order, thereby limiting your losses or protecting your profits. One way to set your stop order is to use a percentage loss as your guide.

Why doesn't everyone use stop orders if they are such a good way to minimize losses? There are several reasons, but the primary one is that relatively few investors are aware of their existence or purpose. Though ignorance may be bliss in some instances, it is more likely to be suicide when investing, especially in very volatile markets.

A buy order is the inverse of a stop order. It stipulates the exact price at which you are willing to buy a security. When your price is reached, the buy order becomes a market order and your stockbroker is then authorized to buy the shares at your set price. You may also stipulate that your buy and sell orders are to remain effective for one day, one week, or until canceled.

Bear markets offer many opportunities to buy good stocks for a song. Take advantage of these opportunities whenever they occur. Do not fear bear markets!

Bruce Jacobs is the author of All About Mutual Funds From The Inside Out.

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