Red-hot inflation and rising interest rates have led to recession fears, causing the stock market to fall sharply. In fact, the S&P 500 had its worst first half in more than five decades this year, while the Nasdaq Composite suffered its sharpest downturn since the Great Recession, and both indexes have fallen into a bear market. Those events have destroyed trillions of dollars in wealth, leaving a sizable dent in many portfolios.
Nevertheless, investors can find comfort in cold, hard facts. Both indexes have been through dozens of bear markets in the past, but all of them have ended in a new bull market, and there is no reason to expect a different outcome this time. Better yet, bull markets have historically created far more value than bear markets have destroyed.
Unfortunately, predicting market cycles is impossible, but each day brings the next bull market a little closer, so investors should be preparing their portfolios now. This advice from Warren Buffett and Peter Lynch can help.
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Capitalize on buying opportunities created by the bear market
Emotions like fear and euphoria are a part of human nature, but they often lead to irrational decisions. Warren Buffett hit on that idea when he said, "Widespread fear is your friend as an investor because it serves up bargain purchases." People tend to be too optimistic during good times and too pessimistic during bad times, meaning stocks are often overvalued during bull markets and undervalued during bear markets.
Peter Lynch had a similar philosophy. He managed the Magellan Fund at Fidelity between 1977 and 1990, and despite facing two bear markets and six market corrections during that 13-year period, Lynch achieved a market-crushing annualized return of 29.2%. Those bona fides make his advice all the more credible. Lynch once said, "A correction is a wonderful opportunity to buy your favorite companies at a bargain price."
In a nutshell, investors can prepare for the next bull market by capitalizing on the buying opportunities created by the current bear market.
Invest in businesses with a durable competitive advantage
According to Buffett, "All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies." A bear market certainly qualifies as a good time to invest, but what does it mean to pick good stocks? Buffett says the most important trait a business can possess is a durable competitive advantage, which refers to a quality or asset that allows a business to consistently outperform its peers.
Competitive advantages come in different shapes and sizes, but investors can find many good examples by examining Buffett's portfolio. For instance, Apple benefits from tremendous brand authority in consumer electronics, Amazon benefits from superior technology in cloud computing and a powerful network effect in e-commerce, and Taiwan Semiconductor benefits from immense scale and cost advantages in chip manufacturing.
However, the first step in identifying a competitive advantage is research. Investors need to know a company (and the broader industry) inside and out before they can possibly assess its competitive position. For that reason, Buffett has cautioned investors to never buy a stock without first understanding the business.
Be prepared to hold through volatility
As discussed earlier, every bear market has ended in a new bull market, and the S&P 500 and the Nasdaq Composite have inevitably recouped their losses. That said, downturns vary in duration and severity, meaning the current bear market could get much worse, and it could last much longer. The worst mistake an investor can make is trying to time the bottom.
More than 80% of the S&P 500 index's best days in the past 20 years took place during a bear market or during the first two months of a bull market (i.e., before it was clear the bear market had ended). Missing those days can do lasting damage to a portfolio. For that reason, Lynch once said, "The real key to making money in stocks is not to get scared out of them."
To summarize, investors can prepare for the next bull market in three ways: Deploy capital in the current bear market, pick stocks that benefit from a durable advantage, and hold those stocks through any future volatility.
