The nine-year stretch of rising stock prices won’t last forever. So now’s a good time for investors to bear-proof their 401(k)s before the next financial storm.
The current bull market, now the second-longest ever and celebrating its 9th birthday on Friday, is most likely in its final stages, Wall Street pros say. That means a bear market will occur at some point, and the stock market will tumble at least 20% from its peak.
What could cause it and when? No one can know for sure. A recession perhaps, or a surge in interest rates and inflation? An unexpected event or investors getting too giddy about stocks and driving prices up to unsustainable levels? All could be the triggers of a big drop in stocks.
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Remember, if you have any money invested in stocks, you won’t be able to avoid all the pain that a bear inflicts on your 401(k). While a drop of 20% from a prior peak is the classic definition of a bear market, most drops are more sizable. The average decline for the Standard & Poor’s 500 stock index in the 13 bears since 1929 is 39.9%, S&P Dow Jones Indices says. A swoon of that size would shrink a $100,000 investment in an index tracking the broad market to roughly $60,000.
Here are some tips to help you and your 401(k) survive – and possibly even thrive – in tough times.
Prepare ahead of time
“The best way to survive a bear market is to be financially prepared before one happens,” says Jamie Cox, managing partner for Harris Financial Group.
That means not having 100% of your money invested in stocks near a market top. It also means maintaining low levels of debt and having some emergency savings to avoid having to sell stocks in a down market to raise cash, he says.
From a portfolio standpoint, make sure your investment mix isn’t too risky. Are you loaded up on high-fliers that have greater odds of suffering steep drops if the market tanks? Make sure you own some “defensive” stocks, such as utilities, consumer companies that sell everyday staples like soap and cereal, or health care names, which tend to hold up better when markets fall overall.
“Investors should take the time to control the parts of their portfolios they can control,” Cox advises.
If, for example, your portfolio was designed to have 60% in stocks, and that percentage has ballooned to 80% due to the long period of rising stock prices, consider “rebalancing” your portfolio now. Sell some stock to get back to your initial 60% target.
Play defense
The time to be aggressive in the market is when stocks are up, and you can make tactical moves likes cashing out stocks, says Woody Dorsey, a behavioral finance expert and president of Market Semiotics, a Castleton, Vt.-based investment research firm. It makes more sense, he adds, to be defensive when the market is entering or in a period of falling prices.
“Does a bear market mean an investor needs to freak out? No. But it does mean you should be more careful,” Dorsey says. “If the market is going to be difficult for one or two years, just get more defensive. Keep in simple.”
One simple strategy to employ is to get “less exposed to the market and raise cash,” Dorsey says. “Most people are not used to that message, but it’s a good message.” While a normal portfolio might consist of 60% stocks and 40% bonds, a bear market portfolio, he says, might be 30% cash, 30% U.S. stocks and the rest in foreign investments and bonds.
Main Street investors could also consider defensive strategies employed by professional money managers, he says. They can buy things that hold up better in tough times, such as gold. Or add to “alternative” investments that rise when stocks fall, such as exchange-traded funds that profit when market volatility is on the rise or funds that can short the market, or profit from falling prices.
Identify severity of bear
The next bear isn’t likely to be as severe as the epic one following the Great Recession or the dive in early 2000 after the dot-com bubble burst, says Liz Ann Sonders, chief investment strategist at Charles Schwab. Both of those bears saw market drops of about 50% or more.
“The next bear will be a more traditional one that likely comes from the market sniffing out a coming recession,” she explains. “We don’t think it will be caused by a global financial crisis or bubble bursting.”
That means fear levels likely won’t spike quite as high. Investors will also have a better idea of when the bear market might hit, as it will be foreshadowed by signs of a slowing economy.
It also suggests the market will likely rebound more quickly than the average bear of 21 months. As a result, employing basic investment principles, such as portfolio rebalancing, diversification and buying shares on a regular basis, which forces folks to snap up shares when prices are cheaper, can help investors emerge from the next bear market in decent shape.
“Diversification and rebalancing are boring to talk about,” says Sonders. “But they are more useful strategies than all the hyperbole on when to get in or get out of the market, which is not an investment strategy.”
Buy the ‘big’ dips
There are big market swings even in bear markets. A way investors can play it is to buy shares on the days or periods when stocks are under intense selling pressure.
“There will be lots of wild swings,” says Mike Wilson, U.S. equity strategist at Morgan Stanley.
Investors have to take advantage of stock prices when they are depressed and present good value, he says, even if it seems like a scary thing to do at the time.
“You have to be willing to step in” when market valuations fall a lot, no matter what’s going on in the world, Wilson advises.
