Even with the U.S. stock market near all-time highs, stocks remain an excellent way to build wealth. But that doesn't mean the path will always be smooth.
Public markets are sometimes bullish and sometimes bearish. In both situations, the market can move by 20% or more. During bull markets, investor optimism propels stock prices sky-high, and during bear markets, pessimism and panic move them down. It's also interesting to note that the 2010 decade has been the longest bull market in history, despite the Great Recession in 2008. Bear markets can be nerve-wracking, which is why these three strategies can help get through these tough times.
1. Keep calm and revisit your asset allocation
The first thing you should do when stocks are falling is stay calm. Recognize that this cycle is temporary. Emotional investing leads to common mistakes such as buying high and selling low. The 2008 financial crisis led many investors to sell substantial portions of their portfolios, and those who did weren't able to take advantage of the S&P 500's 10-year annualized total return of 17.8% since that time. Those who just stayed invested would have recouped their losses -- and then some.
Keeping those returns in mind can help you focus on the right time frame during bear markets. If you're investing for a long-term goal like retirement, your portfolio has time to recover from even large losses. It's also key to be aware of your asset allocation -- the percentage of your assets held in different investments such as stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Optimal asset allocation varies based on your age, risk tolerance, investing goals, and more; a qualified financial advisor can help you figure out what's right for you. A properly customized, risk-adjusted asset allocation plan will serve as your roadmap during market volatility.
2. Consider buying put options
Options trading can be very complex, with strategies including "straddles," "strangles," and even "iron condors." But put options, which can act as insurance during falling markets, are far less complicated. A put option gives you the right to sell an asset at a determined price called the strike price, for which you pay a premium. If you believe indexes or certain stocks will depreciate, you can buy put options for downside protection. Put options are generally sold in batches of 100 and they are sold by an investor who will buy the shares if you exercise your right to sell them.
Here's a hypothetical example:
- You decide to buy 100 put options on XYZ stock, which is trading at $60, for a total premium of $70 (100 options multiplied by $0.70 per contract).
- You choose a strike price of $55, because you believe XYZ stock will fall below this threshold before the option expires. All options have expiration dates, which generally range from three to nine months. The underlying stock price can fluctuate during the option contract, but you'd want it to fall below $55 at expiration in this case.
- XYZ's stock price falls to $40 by expiration; your total profit is $1,430. The formula used to derive this gain is 100($55-$40)-$70 -- the number of shares, multiplied by the difference between the strike price and the final stock price, minus the premium paid.
Put options can be a good way to mitigate risk, but you should always do your due diligence before buying them. They don't carry as much risk as other investment strategies like shorting stocks, because the most you'd lose is the premium you paid for it if the option expires worthless. However, buying options can be risky as paying premiums can add up over time. It also involves more market timing than long-term investors are usually comfortable with. Many options traders constantly monitor their positions, short term market swings, making it more complex than simple buy and hold long-term investments.
3. Invest in stable industries
Industries that are particularly cyclical can be among the most volatile. Consider the travel industry, in which demand can rise during prosperous times but profits may fall when there's a downturn and consumers need to save money on discretionary expenses.
You can avoid panic when a bear market comes by investing in recession-proof industries now -- consider consumer staples companies such as Procter & Gamble (NYSE:PG) which owns several common household brands, including Pampers diapers, Tide laundry products, and Tampax tampons. These are common household items that will always be needed, regardless of the state of the economy. While these companies' stock prices can fluctuate with the market, they usually increase over the long term, pay consistent dividends, and are profitable. For example, Procter & Gamble's stock price has increased by more than 100% in the past 10 years. Besides this, investors collect a healthy dividend yield of 2.39%.
Keep the bear market in context
Public markets and economies go through numerous, temporary phases. Recognize that even the worst of times aren't permanent and that if you don't panic, your portfolio will be able to see it through. Keeping calm, hedging with put options, and investing in recession-proof industries will all make it easier along the way.