3 ways to plan, prep, and profit from the next bear market

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Plan and prepare to profit from the next market downturn.
We're LONG overdue for a bear market. Here's three ways to plan and prepare to profit from the next market downturn.

3 ways to plan, prep, and profit from the next bear market

 

It’s not a question of “if”, it’s a question of “when”. We will undoubtedly experience another major market setback at some point (probably soon).

No, I am absolutely NOT predicting a bear market. I am no market prognosticator, and no one else is either (though statistically some analysts will get lucky and call it skill).

Being 8 years into a bull market, it’s only a matter of time. Stocks can’t keep going straight up forever, right?

We’ve scarcely experienced a market correction in the last 8 years. We lived through some hiccups here and there, but they were minor annoyances in retrospect.

So what does this mean for you as an investor? It means you’ve got to prepare, you’ve got to plan, and you’ve got to not only survive, but profit from the next bear market!

 

What is a bear market?

 

When will the next bear stock market hit?
Bad stock markets are easily managed if you’re prepared ahead of time.

Most investors describe a bear market as a drop of 20% or more. Some people put timeframes on it, such as over a two month period. Other’s have a different percentage drop in mind. Regardless, it’s a noticeable drop in value from high to low points.

While bonds can experience a bear market as well, most of us are only fearful of stock bear markets. Bonds don’t drop as far after all, because they’re more conservative by nature.

A stock bear market is very different from a market correction. Most people define a market correction as a drop from 10% to 20% off the highs. Corrections are far more common obviously.

No market drops are fun. They are however, part of the process.

While they’re no fun, if you plan and prepare, they can be not only tolerable but profitable.

 

#1 Put stock market drops into perspective

 

Bear markets and corrections come and go. What makes them so painful is the fear that somehow, “it’s different this time”.

It’s not different this, last, or any future time. Markets are volatile, plain and simple. They rise and fall with wars, expectations for the future, world events, natural disasters, economics, and on and on.

Women are better investors than men are. There’s a big reason for this! They stay calm. They shun knee-jerk decisions, and prefer to “slow-play” important choices such as “should I sell or stay invested?”

Stay calm. That’s the number one thing you must remember, is stay calm. If it helps, just try to invest like a girl!

To put market drops in perspective, take a look at the chart below:

 

Investing is a process that occurs in good and bad markets
Bear markets are temporary. It’s important you put them into perspective.

 

From 1926 to 2015, there have been 25 bear markets and/or market corrections. Some far worse than others, but 25 of them have occurred over that 89 year period.

If history repeats itself, that means roughly 1 in every 4 years we will be forced to deal with a nasty stock market. Since we haven’t had a bear market since the Great Recession, we’re definitely long overdue.

 

It takes time to work through a bear market

 

The average bull market lasts 31 months. The average bear market lasts 11 months. That’s nearly a year of stomaching nasty value drops from your stock portfolio.

Notice I said “value drops”. You don’t lose if you stay calm. You don’t lose unless you consciously decide to lock in those value drops.

 

 

The losses aren’t proportional to the gains

 

Consider for a moment that a bear market is about a third as long as a bull market. While nobody likes a bear market, they’re truncated in respect to the big picture. Bull markets average out to gains of 113%. That’s POWERFUL!

Bear market losses amount to an average of 26%. I would think the returns would be somewhat proportional to the length of time, but they’re not.

Here’s what I mean:

  • Average monthly bull market gain – 3.64%
  • Average monthly bear market loss – 2.36%

Not only do bull markets last longer, but the movement is greater as well!

 

Market corrections happen every year

 

The chart below is one of my top 3, if not my all time favorite. It looks like a lot of investing noise, but it’s quite simple.

The blue bars are the stock market results for each calendar year. The blue dots are the highest gain point for each year. The red dots are the lowest loss point for each year.

 

Stock market corrections happen every year.
The stock market corrects each year about 14% on average.

 

Why is this my favorite chart? Because each year the market experiences some nasty pullbacks. Some years it’s worse than others, but every year the market sells off at some point.

If you average out all of the red dot intra-year stock market losses, it’s about 14%. That means that each year, on average, the stock market will drop 14% from high to low point.

Whether it rises then falls, or starts off poorly and recovers, the market will drop every year in noticeable fashion.

 

Be wary of the news

 

While the market drops every year, the “newsactors” on CNBC (and whatever other media you’re following) will always pretend to know why. One of the best things you can do right now is mentally prepare yourself to “ignore the financial noise”.

The newsactors on TV need to keep you coming back. Without viewers they can’t sell advertisements. So they’ll tell you why the market is dropping and what they think it will do next.

The fact is they don’t know. They’re just using whatever current excuse or reason they have to pretend they know all the answers. They don’t.

It’s far too simple for the news media to tell you “market corrections are normal, they happen each year, relax”. That approach wouldn’t sell many ads though would it?

Rather, they pretend to know the answers. This makes their viewers think they can help them navigate the turmoil best.

They don’t have the answers. The stock market drops every year. It’s normal. Relax and turn off CNBC.

 

#2 Have a financial plan as your foundation

 

People tend to focus too much on investing and not enough on financial planning. Financial planning is far more critical to your lifetime success than the investments you choose.

If you have a cohesive financial plan working for you, you’re far less likely to make a mistake when the stock market sells off. A quality financial plan has many benefits to help you not only weather, but thrive during a bear market:

 

  • Your near term financial needs are not only accounted for, but allocated to more conservative investments like bonds and cash. A bad stock market doesn’t affect you (other than emotionally) if your near term cash flows are set up properly.
  • Your long term investments are diversified, and balanced to your financial needs. The investment plan you choose should be based not only off your tolerance for risk and volatility, but your long term return needs and short term risk capacity for losses. If all three of these investment aspects are working in concert, your chances to survive and thrive in a bad market skyrocket!
  • A financial plan includes a rebalancing policy. Rebalancing forces you to buy low and sell high. In a bad market, you’ll be buying more stocks, not selling them! You’ll likely be lightening up on your bond allocations to do so, and your bonds have likely been steady performers for you when stocks are bad.
  • Your investment plan will change for the good in a bad market. Financial planning software is highly complex. One of the coolest things a financial plan does, is statistically analyze if you’re in the best investment allocation for your situation. This analysis is critical to thriving in a bad market. When your account values sink, it may be more appropriate for you to take a notch up in stock exposure. Conversely, as the markets are soaring, the software raises the question “Should you reduce risk and lower your equity allocation?” Without a financial plan, you’d have no mathematical way to analyze these critical decisions.
  • A financial plan will simulate bear markets before they happen. We call it a “lifeboat drill”. The important part about bear market simulations is we run our clients through them while things are good. If your financial plan can weather the nastiest of stock market storms, what are you worried about anyway? If you’re unsure whether you’ll survive or not, you have a major problem on your hands – because the next financial storm is coming, and soon!

 

Investing is nothing more than a tool – or a process – to execute a great financial plan. Financial planning isn’t sexy though. It’s not fun to discuss at a cocktail party, and frankly it takes a lot of work and effort to do it properly.

The main reason people fail in bad stock markets is they’ve failed to plan ahead of time. Without preparation, you’re prone to highly emotional – and fearful – decisions. Emotion and fear is a precursor to financial disaster!

 

#3 Prepare yourself financially

 

What is it you’re really worried about with the next bear market anyway? While I realize it’s painful to watch your account balance drop, what’s at the core of your fear?

I suggest most investors fear declining account values because they’re not prepared to navigate them. The first step of staying calm helps. The second step of putting the financial planning process at the forefront goes even farther.

A third and final step is to actually execute on what matters. So what really matters?

Facts are facts. The average bear market lasts less than a year. In it’s most simple form, why not have 11 months of living expenses and liquidity set aside in anticipation of the next big bear market?

With no other planning or options, this simple strategy could save your financial life! After all, a bear market only negatively affects those who actually sell stocks for a loss.

If you can maintain your stock allocation – even increasing it into a bad market – what’s there to worry about? Bear markets then just become a “part of doing business”.

 

It’s not that easy unfortunately

 

Your financial plan will dictate what mix of stocks and bonds are appropriate to accomplish your financial goals. That’s the good news! Your portfolio will have a target rate of return, general volatility statistics, and inflation expectations.

The problem with a year (or more) of liquidity, is those amounts set aside won’t earn what your balanced investment plan is required to over time. This can potentially cause you to fall short of your financial goals.

Enter bear buckets and bear sliders. Those are my fancy little names for two strategies I feel are ultimately critical to thriving in a bear market.

 

What is a bear bucket?

 

A bear bucket is exactly what I described – a safe, relatively liquid investment pool of money. When the stock market turns nasty, the worst thing you can do is sell shares at lower prices to generate any cash flows you may need.

The best thing you can do in a bear stock market, is buy stocks cheap! I think we’d all agree that buying stock funds in 2008 when the junk hit the fan was a genius move. The bear bucket strategy forces you to do just that.

When the stock market is getting pummeled to the tune of 20%, turn off the “cash flow spigot” from your main investment portfolio. The goal is to never sell stocks cheap after all, and this is the easiest way to follow that golden rule.

Any cash flows you need for living expenses or financial goals should be drawn from the bear bucket. This allows you safety and security of your cash flow needs, while also forcing you to buy stocks cheap per your rebalancing protocol.

NOTE: The goal of a bear bucket fund is to provide a stable source of emergency cash flow. One thing we don’t know is when we’ll need it. For this reason, I prefer at a minimum to protect my purchasing power with short term treasury inflation protected securities. They have very low volatility, very low risk, and the objective is to maintain buying power adjusted for inflation.

The biggest question is “How much money goes into my bear bucket?” That’s also the hardest one to answer. Every investor is different.

Some are willing to keep small bear buckets knowing they can reduce their cash flow needs if necessary. Other investors want a year or more of bear bucket funds set aside.

Remember, when the bear bucket gets too large, your overall investment portfolio will return less.

I prefer smaller bear buckets with a bear slider strategy layered on top. Depending on the client situation and financial needs, from 6 to 10 months of cash flows should be set aside in the bear bucket.

 

Adding a bear slider to the bear bucket

 

I’m not trying to get too fancy with my terminology, but it makes sense. If the average bear market is 11 months long and I have 6 months of cash flows in my bear bucket, it’s highly likely I’ll need additional backup planning in the form of extra liquidity.

Ask yourself this question: “when it it most advantageous to invest aggressively?”

The consensus opinion is to invest aggressively when the markets are humming along and things are good. This is just plain wrong!

When you really benefit the most from investing aggressively is in the troughs of a bear market. Stocks are cheap, you can buy more shares at lower prices for the impending bull market recovery.

 

It’s hardest to invest aggressively when it’s the best time to do it

 

The bear slider strategy forces you to do exactly that! The bear slider requires an unwavering decision to never sell stocks in a bear market.

“Wait a second”, you’re thinking… I ran out of liquid reserves from my bear bucket, and I need cash to live on and fund my financial goals.

This can be a troublesome situation without addressing it ahead of time.

The unwavering decision to never sell stocks forces you to only sell bonds for cash flow needs. Unless you’re heavily weighted to stocks, you should have a fairly substantial allocation to bonds, plenty enough to get you through the remainder bear market.

Bonds are not correlated with stocks. They go up and down in value independently of what the stock market does.

We also typically experience what’s called a “flight to quality” during bear stock markets. During these nasty times, investors pour money into bonds instead of stocks, pumping up prices and generating (likely) positive returns.

Since your bonds are probably performing well, you sell bonds only to generate necessary cash flows. This has a very obvious effect of increasing your stock allocation, hence the “slider”. As bonds are sold, stock allocations rise and your overall asset allocation slides more aggressive.

Anecdotally, for most retired clients living on portfolio and other retirement income cash flows, this equates to 1% to 2% per month in equity allocation increases.

 

Let’s run this bear bucket bear slider scenario through the 2008 meltdown

 

Most of our clients have asset allocations of 50% to 65% in stocks, and the rest in bonds. We’ll assume a 60% stock 40% bond starting point.

The stock market hit it’s peak in November of 2007. A couple months later, we were officially in bear territory. Let’s call the initiation of the bear bucket in January 2008.

By June of 2008, your bear bucket is empty. You’ve survived 6 months of an eventual 18 month meltdown while rebalancing and buying stocks as they sank.

Starting July 2008, you make a focused decision to only liquidate bonds for your cash requirements. Assuming the math works out to a stock allocation increase of 1.5% per month, you go from 60% stock to 78% stock over the June 2008 to June 2009 period when the bear market ended.

This may sound scary, increasing your stock allocation to 78% in the worst market since the Great Depression. I’ll admit, it’s absolutely nerve-wracking!

Nonetheless, you increased your allocation to stock investments. You did this like clockwork during the best buying opportunity in over 70 years!

While this increasing stock strategy may be scary, what are your options? Keep selling stocks during one of the worst periods in history? Have a bear bucket so large it costs you the needed investment returns to achieve all of your goals?

In major bear markets – like 2008 – the process will still be disruptive emotionally. In minor bear markets – like 1998 – you would have escaped relatively unscathed with these strategies in place.

 

Oh, and don’t forget to refill your bucket and slide your portfolio back in line!

 

Once used, the bear bucket must be replenished. You’ll never know the perfect time to do so, but it must be done.

Bull markets are so much longer and more robust than bear markets. Funneling money each month or quarter back into the bear bucket once things “normalize” shouldn’t be nearly as difficult as implementing the strategy in the first place.

Finally, your asset allocation must be put back in line with your original plan intentions. Slide that investment policy from 78% back to 60% stocks. This again forces you to sell stocks high as you’ve exited the bear market, buying bonds to balance your investment plan again.

 

3 ways to prepare and profit from the next bear market in summary

 

Stock market drops are normal, put them in perspective. Stay calm, and turn off CNBC. If anything, slow play your investing decisions like female investors do. You’ll be well served by removing emotion from the decision making process.

Bad markets come and go as well. Plan for a 14% drop each year on average. If you expect it, you’re more likely to handle it with confidence.

Your financial plan is far more critical to your success than the investments you choose. You must have a great financial plan at the foundation, or you’re doomed for failure.

That financial plan must include regular investment allocation checks. Those checks will help you adjust your portfolio over time as market conditions and your financial needs change.

Your financial plan must also include a lifeboat drill. If your plan succeeds in nasty markets – even through they’re simulated – your chances of success skyrocket!

Finally, have a cash flow contingency plan in place ahead of time. We call these our bear market and bear slider strategies. If you have your cash flows planned and accounted for, you’ll be far ahead of the game. If you’re willing to increase your allocation to stocks in a nasty market – all the better!

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