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  • Bear markets are painful, but a move to new highs has always followed them.
  • Long-term investors can use bear markets to increase exposure to index funds.
  • Strategies can help active investors minimize drawdown.

Traders and investors hunt for 'good" stocks breaking out or pulling back to support in a bull market. In a bear market, investors bargain hunt stocks while traders sell at resistance.

If you're a buy-and-hold investor, you don't necessarily 'care' if you're timing the exact low of the stock market because you're balancing risk to reward over many years, not months or days.

For example, suppose you're investing in a diversified index fund like the S&P 500. In that case, history shows that dollar-cost averaging into index funds during a bear market is profit-friendly because you wind up with more shares at a lower cost the next time bulls regain the field. Remember, every bear market has preceded a move in the S&P 500 to a new high, including terrible tapes in 2008/2009, 2018, and 2020.

S&P-500-Chart-042722

Moreover, the 38% average return in the first year of a bull market is significantly higher than the average 12% return in the second year. And missing even a few of the best-performing days can seriously dent long-haul returns. For example, if you weren't in the market during the ten best days between 2002 and 2021, you missed out on 334% in cumulative return, according to J.P. Morgan Asset Management.

Long-term returns suggest using bear markets as an opportunity to buy index funds at lower prices is the best strategy for many investors. Still, it's more complicated if you're investing in individual stocks or have a shorter-term time horizon.

Bear markets can create headaches if you aren't careful. You don't need to look hard for examples. Nearly half of NASDAQ stocks have dropped by 50%, and many stocks have fallen more. For example, Coinbase and Upstart have lost 80% of their value since peaking last fall.

Minimizing your drawdown to "live to fight another day" is important, so here are five tips that can help protect your portfolio.

No. 1: Cash is a position

Just because the market is open doesn't mean you have to do anything. Bear markets are notorious for short-lived relief rallies. Those bounces can be eye-popping, but often, stocks will roll over to new lows. For example, the NASDAQ 100 has rallied multiple times this year, but the longest one lasted only 11 days. If you didn't time your entry and exit perfectly, you got stung. Make cash one of your most significant positions to protect yourself, then deploy it patiently and incrementally. There will be plenty of money-making opportunities when there's more conviction.

No. 2: Avoid or significantly limit your use of margin

Bear markets can be portfolio killers if you buy stocks on margin. The devaluation of growth stocks caused by increasing interest rates can lead to margin calls, forcing you to contribute more cash with little to no benefit. Too often, a trader settles margin calls only to see stocks rally, roll, and make new lows, resulting in more margin calls. Eventually, the broker force-liquidates your holdings when all your cash is gone, wiping out your account. Don't let that happen to you.

No. 3: If you can't beat 'em, join 'em

Shorting stocks allows you to profit when stocks fall, so doing so can reduce drawdown. A couple of words of advice, though. First, be careful (or avoid) shorting high-beta (volatile) stocks at this bear market stage. Relief rallies begin on short-covering, so heavily shorted, highly-volatile stocks can rally significantly in brief spurts. For example, buy-now-pay-later darling Affirm rallied 89% from its low on the 12th through earlier today. One alternative? Use an exchange-traded fund like ProShares Short S&P 500  (SH)  to hedge some of your exposure until the bear market is over.

No. 4: Plan trades and trade plans

Sometimes, the stock market seems like the Wild West, but you shouldn't trade like you're a gunslinger. Reacting to the day's market moves is a surefire way to churn your portfolio. First, develop a plan for each stock you want to buy or sell, including a thesis for why you're putting the position on, an entry point, and an exit strategy. Then follow your plan!

No. 5: Pay attention to the economic cycle

Stocks perform differently at different stages of the business cycle. For example, consumer discretionary and information technology stocks do very well when the Fed is cutting interest rates, and as a result, the economy is accelerating. But they underperform when the opposite is true. If you pay attention to where we're heading in the cycle, you can proactively adjust your exposure to specific sectors, potentially reducing your drawdown. For instance, recognizing the economy was shifting to the late-cycle in December allowed you to increase your weighting to commodities, such as energy, that benefit when inflation is high. Similarly, understanding the risk of recession because of rising rates allowed you to overweight recessionary-stage stocks, including healthcare, utilities, and consumer staples, which have also outperformed this year.

The Smart Play

Eventually, the Fed will be friendly again, and early cycle stocks will rally. But, there's little evidence to suggest a change of heart at the Fed, so playing defense until then remains smart.

Defensive stocks in recession-stage sectors tend to have lower beta, price to earnings, price to sales, and price to book ratios. As a result, they're typically less volatile, so they decline less, making them worth owning in a bear market. If you don't know what value stocks to buy, consider the iShares S&P 500 Value ETF  (IVE)  or the iShares Russell 2000 ETF  (IWN) .

If you're a long-term investor, try to make the most of the market's weakness. First, target a contribution rate of 10% to 15% of your income and dollar-cost average into a diversified index fund in a workplace retirement plan. If you can't contribute that much of your income yet, see if your retirement plan offers an auto-escalation feature that can incrementally increase your contribution rate over time.

If you're a trader or a shorter-term investor, proper planning is key to surviving a bear market. Hold a larger than normal cash position, avoid margin, hedge some of your risk by shorting, plan every trade, and adjust your sector exposure based on the business cycle. 

  • Bear markets are painful, but a move to new highs has always followed them.
  • Long-term investors can use bear markets to increase exposure to index funds.
  • Strategies can help active investors minimize drawdown.
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