Strategies for investing in bear markets

This is the final part in a series of three posts on riding out a bear market. To be sociable and mix things up a bit, the first two posts are on two other splendid financial blogs:

• MoneyNing (Part 1: Beat market volatility by being boring)
• Investing School (Part 2: Ignore your portfolio for months at a time)

Read those parts first, then come back to read the final post below.

If you’ve already read those and you’re new to Monevator, welcome aboard! If you like what you’ve read, please do consider subscribing via RSS or email.

Strategy 3: Try to invest when the market is down

The best antidote I know for beating bear market blues is to buy when the market is down.

Averaging down can be a dirty word among traders, but value-orientated equity investors should welcome the chance to buy companies they believe in at a cheaper price.

And buying when the whole market is cheaper, that’s another matter altogether.

Here you’re not chasing a bad decision in a stock as you might be when averaging down. Instead, you’re reinforcing your good decision to invest in equities for the long-term.

If you want to ensure you get the big returns from stocks that investment writers highlight when urging you to invest in equities, you need to buy during bear markets to make up for the lousy returns from those years when you buy at what proves to be the top of a bull market.

It’s true that if you could find a way to consistently get out of stocks before a bear market struck, you could forget about getting rich slowly. Wall Street would beat a path to your door!

But most investors will never manage to get out before a stock market plunge, by definition. The bull market that precedes the bear is the result of the surge of buying and optimism that overwhelms the money of those naysayers.

What too many investors do instead, is get out of the market completely after the bear market strikes. Like this, they crystallise their losses, and risk missing out on the stock market’s recovery.

According to Bloomberg, U.S. investors withdrew a record $194 billion from stock and bond mutual funds in 2008.

These investors who contributed to the worst equity market in 70 years by selling may currently derive some comfort from knowing they can’t lose any more money in stocks. But to make money from the stock market, at some point they will need to get back in.

How high do you buy?

Judging when to reinvest in an under-valued market is at least as hard as selling out of an over-valued market. The risk to the investor on the sidelines is that he or she leaves it too late, and misses much of the upside from the next bull run.

A study earlier this decade by SEI, the asset manager, found investors paid a heavy price if they missed the start of the bull market by staying in cash too long.

According to a MarketWatch report, in a study of 12 post-World War II bear markets:

• Investors who held their stocks through the bear market gained an average of 32.5% during the first year of recovery.
• Investors who bought one week after the market rally began saw a 24.3% return.
• Those who waited for three months before jumping back in achieved only 14.8%.

In reality, many investors won’t even buy stocks again after three months!

The painful losses will still be fresh in their memory, and they’ll worry the recovery is a temporary blip, which of course it may well prove to be. So they’ll wait until the talk of huge gains from stocks overwhelms the memory of the losses they endured during the last market fall, and finally buy in well into the rally.

Such investors think they’re being prudent, when it reality they’re amplifying their risks by eventually buying into a market that is more expensive and that offers far less upside then when things looked bleakest.

I know people who were still waiting for a bear market to return in 2005, some five years after the start of the dotcom crash and well into the next bull market.

Those who finally jumped back into the market in 2007 paid a heavy price. They have suffered all the declines of the 2007 to 2009 bear, with little of the previous bull market gains to cushion their losses.

Buying the bear on auto-pilot

The easiest way to sidestep all this agony is to dollar-cost average into the market by regularly saving and investing into an equity vehicle, preferably a passive index tracking fund or ETF.

This video from Mike at Oblivious Investor shows how with dollar-cost averaging, the volatility in the market goes from being your enemy to your friend.

Dollar-cost averaging your money into a broadly diversified stock market investment like an index tracking ETF held for the long-term combines all three psychological tactics I’ve discussed in this series into one winning strategy:

1) Nothing could be more boring than a regular investment into a passive index tracking ETF

You’re more likely to check how that paint is drying than your stocks. You’re therefore less likely to be scared out of the market because of short-term losses.

2) If you invest via an index tracking fund rather than via ETFs, watching your stocks gets duller still

With a bit of luck you might find a manager who only supplies you with an update once a year. Since markets generally go up over the long-term, most years you’ll be happy to receive it.

3) Market up? Market down? No worries.

When stocks are rising you’re richer, and when they’re falling you can take comfort that you’re buying more equities for your bucks. It’s a win-win situation.

Investing in the stock market will never be as easy as putting money in the bank, which is one of the main reasons why it offers greater rewards.

But by investing with an awareness of your human frailties, you can at least make investing life easier for yourself, and with luck enjoy a richer retirement as a result.