Can long-term investors, with at least a couple of decades of investing ahead, realistically protect themselves from a bear market? By definition a bear market means that one of the averages -- generally the Standard & Poor's 500 or Dow Jones Industrial Average -- has dropped at least 20% from a high. Given the pain of a 20% loss, I think the question is worth asking. That said, just because a question is worth asking and thinking about doesn't mean investors should be taking action.
Investors with a distant horizon, who primarily invest in index funds, and are able to continually add to their savings are generally best off to continue down the same path. As this chart shows, over long periods of time the market rewards those who are patient, particularly frequent investors, and that doesn't include dividends, which only make the story better.
As much as I believe in long-term investing and continually adding to savings, I know that sometimes it is not always practical, or even possible. Perhaps, like myself, you have money invested in a retirement account and a brokerage account, but you have been saving for a home and were unable to add funds to either account for a long stretch of time.
Because that situation did recently apply to my family's savings, I've been giving it a good deal of thought when I'm not thinking about the Red Sox's 2005 roster or where Starbucks
Who bought this?
"Know what you own" sounds easy enough. After all, as individual investors we more than likely purchased each of the stocks we hold. Ah, but it's not always that easy. Sure we know the names of the companies and perhaps even a fair amount about the company's financials and the past performance of the shares. That's not enough, though, and as an investor who's been caught off guard in the past, I think it makes sense to keep a notebook with one page dedicated to each company.
For each company, I keep track of when and why I purchased the stock, how the company drives sales and profits, and what risks or threats the company faces. This is on top of any portfolio tracking.
Earlier this year, I added another rule that I have to complete the write-up at the time I'm purchasing the stock -- not a few months later. This forces me to know what I own and to read a company's available filings, before making a purchase.
I try to update each company at least twice a year. When I find I'm falling behind, that's a real sign that I'm holding more stocks than I can keep up with, which is a risk in itself. But, the real method behind the madness is that by knowing what I own in fairly good detail, I'm less likely to be scared into selling at the worst possible time.
Only the strong survive
Debt is often a necessary and sometimes preferred method of funding business expansion. However, for the best bear market protection I want companies with solid balance sheets, because even great companies can experience a dip in their cash flow during an economic slowdown. Some debt is OK if cash flow is ample and historically steady, but large debt loads or debt that sucks up the majority of available cash flow is a large red flag and exactly the type of bear market disaster I want to avoid.
Although I never took a job in accounting, I have a big soft spot in my heart for companies with strong balance sheets. This is because I had the pleasure of spending four years getting Assets = Liabilities + Owners Equity -- among other valuable, but mind-numbing subjects -- drilled into my head during college. All of the companies I have invested in have little or no debt, except for two turnarounds, which are working down their debt: Motley Fool Hidden Gems selection and death-care provider Alderwoods
What's it worth to ya?
Valuation can be an intimidating subject. And while I'm a big fan of discounted cash flow analysis, I also know it's taken me some time to get comfortable with valuation and that in some ways it's really an ongoing learning experience. With all that said, don't let valuation intimidate you or even slow you down, because what it really comes down to is trying to pay a reasonable price.
If discounted cash flow analysis isn't your cup of tea, consider a historic analysis of a company's price-to- earnings ratio (P/E), or compare the earnings -- or free cash flow -- growth rate and the return on equity to the P/E. If the earnings growth rate and the return on equity are higher than the P/E and you can find corroborating evidence that the growth will continue, a bear shouldn't be able to do too much damage to your purchase.
Get in the balancing act
There are many portfolio allocation strategies out there, but one stands out for bear market protection, and that is purchasing companies that pay you to hold them. Those sleepy old dividend payers don't just pay out on a regular basis, but they also tend to beat the market over the long haul. For my personal bear market protection I want to have at least 40% of my portfolio in dividend payers, because investors in tough markets are attracted to that delectable yield.
As with all good things, it is possible to overdo it. Generally this happens when the focus of the investment is entirely on the dividend, and it's a dangerous trap. Instead, try to focus on investments that stand out on their own right and where the dividend is the icing on the cake. A couple of retailing opportunities in this area that I'm paying attention to are The Limited
Margin, the potentially destructive force within
Margin is simply a loan against your existing investments allowing you to buy more shares -- for more details, see this link. Like all debt, margin is generally used well when used in moderation and it can help give your returns some extra juice. At the other extreme, margin will allow you to fully double the amount of money you have invested. On the surface this may sound nice, but the margin knife cuts both ways, and if your stocks fall -- as they do by definition in a bear market -- you could be left with very little of your original portfolio. Among all the stories of investors getting pummeled by bears, those who get beat by margin often left themselves with little or no wiggle room for bear market declines.
Like many things in life, being successful through a bear market isn't so much about what action you take during the crisis, but about understanding what risks you're signing up for up front. There will still be some unavoidable surprises and potentially some pain, but as Fools with decades of investing ahead of us, we should look at bear markets not as threats, but as opportunities, because history shows us that every bull eventually leads to a bear and each bear to yet another bull.
For related Fool analysis, see:
- Beating the Big, Bad Bear
- Battling the Bears
- Introduction to Valuation
- Mulling Over Margin
- When Bear Markets End