The Nasdaq Composite and Russell 2000 are already deep into a bear market -- which is a decline of 20% or more from a previous high. And after this week's sell-off, the S&P 500 is now just a few percentage points away from a bear market as well.
Walt Disney, Amazon, Meta Platforms, Starbucks, and Adobe are just a handful of names on the long list of companies whose stock prices are down 40% or more from their all-time highs. Other once-darling growth stocks like Shopify (SHOP 1.70%) and Netflix have seen their share prices fall over 75% from their peaks.
Bear markets can create life-changing wealth by giving investors buying opportunities, but that doesn't mean it's time to dive headfirst into the abyss of this situation without a plan. Here are three mistakes worth avoiding during a bear market.
Investing in companies you don't understand
Probably the easiest way to lose money in a bear market is to invest in businesses you don't understand. Several companies saw their valuations balloon to nosebleed levels over the last few years. Thrill-seeking investors looking for high-risk, high-reward stocks poured into these names, many of them without understanding the fundamental business. The result was big swings to the upside followed by catastrophic losses on the downside.
During a bear market, things get very real very quickly. An investor watching their portfolio go from forest green to scarlet red in a matter of months without knowing why is prone to losing patience and running for the exits. If you don't understand the companies you own, it's hard to know what decision to make and when.
Bear markets put fundamentals to the test. Companies with good cash flows and healthy balance sheets tend to outlast bear markets and grow over time. Those that don't tend to get weeded out.
Anchoring all-time highs as a fair price or a price the stock will reach again
Another big mistake investors can make is thinking that a stock's all-time high is a fair price or a price the stock will one day return to. After all, if a stock is down 80% from its high and returned to that high, that would be a 500% return. Sorry to say, but many stocks will never reach the all-time highs achieved in 2020 and 2021. Or if they do, it could take a long time.
As mentioned above, Shopify stock is down over 80% from its all-time high. Despite compelling fundamentals, strong growth, a well-run business, and the tailwinds of the e-commerce industry, Shopify stock still isn't cheap by any means. The company has a much more attractive risk/reward profile now that the stock price has decreased by so much. But that doesn't mean Shopify should sport an over $200 billion market cap (which it did at its peak) until it proves it can sustain a high growth rate and achieve a consistent gross margin.
However, just as many growth stocks swung way too far to the upside, others have swung way too far to the downside. Even though Shopify is expensive, the risks are starting to look a lot less scary relative to the reward. Shopify has its problems, but at the end of the day, it is an incredibly well-run company with tons of growth potential. Probably the worst part about Shopify is its valuation. Since that problem is a lot less of an issue now, it seems like a good time for investors to begin considering stocks like Shopify.
That being said, going into such a stock on the assumption it will return over 400% in the short-term is the wrong approach. Rather, it's best to approach down-beaten growth stocks with quality fundamentals as businesses you believe in and are comfortable owning over at least a five-year time frame.
Gambling on speculative stocks
Another big mistake is to try to catch a falling knife on a company that is down big simply because the stock is down a lot. This mistake is a combination of mistakes one and two and a common decision investors will make in a bear market. The temptation to see a stock that has sold off and try to buy the dip without knowing why can lead to painful losses. The percentages may shock you.
Let's pick on Roku (ROKU 4.68%) and Robinhood Markets (HOOD 0.06%). On Jan. 1, both companies were already down 50% to 75% from their all-time highs. But since then, each stock is down an additional 50% to 65%.
The math sounds confusing at first, but it makes more sense with real numbers. Let's say an investor bought a stock for $300 per share in 2021, and then it opened 2022 at $100 a share. That would be a 67% loss. Then, four months later, the stock was $50 per share. The drawdown from the high is 83%. But even the investor who bought the stock down 67% at the start of the year would already be down 50%.
This exact scenario has played out with many growth stocks that have fallen from grace. Granted, that doesn't mean all are bad. In fact, some look like phenomenal buys now. It's just to say that because a stock is down big doesn't mean it can't roil investors that try to buy the dip.
Let time be your best friend
Instead of trying to be a hero and swinging for the fences during a bear market, the best course of action could be to simply save what you can, dollar-cost average into the stock market (especially when stocks are on sale), and stick to quality companies with strong fundamentals and the best chance of persevering through this and future bear markets. This plan may not present the most upside, but it certainly offers a risk/reward profile that makes sense to most investors.