How to invest in a bear market?

Like a bear with a sore head, many investors probably wish they had stayed in hibernation in 2022. It has been a brutal year so far, the worst since the Great Depression nearly a century ago.

What is a bear market?

A bear market is defined by a prolonged drop in investment prices — generally, a bear market happens when a broad market index falls by 20% or more from its most recent high. This year in 2022, the S&P 500 had dropped by more than 25% from its peak.

While 20% is the threshold, bear markets often plummet much deeper than that over a sustained period, not all at once. Although the market has a few occasional “relief rallies,” the general trend is downward. Eventually, investors begin to find stocks attractively priced and start buying, officially ending the bear market.

Bear markets are characterized by investors’ pessimism and low confidence. During a bear market, investors often seem to ignore any good news and continue selling quickly, pushing prices even lower.

While investors might be bearish on an individual stock, that sentiment may not affect the market as a whole. But when the market turns bearish, almost all stocks within it begin to decline, even if individually they’re reporting good news and growing earnings.

The battle to tame inflation

Central banks have been forced into action as inflation in most major economies has already hit 40-year highs and continues to rise. It’s brought about stark reminders of the dark days of the 1970s and early 1980s, often called the Great Inflation.

This time it’s been exacerbated by pent-up demand following the end of Covid lockdowns in most major economies, combined with supply constraints caused by Covid lags in Asia and war in Ukraine. See how my equity portfolio had been battered by this bear market…

How to invest during a bear market

1. Make dollar-cost averaging your friend

Say the price of a stock in your portfolio slumps 25%, from $100 a share to $75 a share. If you have money to invest — and want to buy more of this stock — it can be tempting to try to buy when you think the stock’s price has cratered.

Problem is, you’ll likely be wrong. That stock may not have bottomed at $75 a share; rather, it could tumble 50% or more from its high. This is why trying to pick the bottom, or “time” the market, is a risky endeavor.

A more prudent approach is to regularly add money to the market with a strategy known as dollar-cost averaging. Dollar-cost averaging is when you continually invest money over time and in roughly equal amounts. This helps smooth out your purchase price over time, ensuring you don’t pour all your money into a stock at its high (while still taking advantage of market dips).

There’s no doubt that bear markets can be scary, but the stock market has proven it will bounce back eventually. If you shift your perspective, focusing on potential gains rather than potential losses, bear markets can be good opportunities to pick up stocks at lower prices.

2. Diversify your holdings

Speaking of picking up stocks at lower prices, boosting your portfolio’s diversification — so it includes a mix of different assets — is another valuable strategy, bear market or not.

During bear markets, all the companies in a given stock index, such as the S&P 500, generally fall — but not necessarily by similar amounts. That’s why a well-diversified portfolio is key. I highly recommend to buy the VOO and SPY, which are the exchange traded funds (ETF) of S&P500. The lower annual operating expense fees of 0.03% also meant less shavings of your portfolio and more for compounding interests to work its magic. If you’re invested in a mix of relative winners and losers, it helps to minimize your portfolio’s overall losses.

3. Focus on the long-term

Bear markets test the resolve of all investors. While these periods are difficult to endure, history shows you probably won’t have to wait too long for the market to recover.

Don’t start selling your positions, hoping to buy them back again when the market goes lower. See strategy 1 above, dollar cost average (DCA) instead. This will enable your portfolio to recover earlier and increase profitability than those who didn’t DCA.

If you’re investing for a long-term goal — such as retirement —  the bear markets you’ll endure will be overshadowed  by bull markets. Money you need for short-term goals, generally those you hope to achieve in less than five years, should not be invested in the stock market.

The bottom line on bear markets

It can be scary to see stock prices fall 20% or more from a recent high — but the one thing investors shouldn't do is panic.

The average bear market lasts less than a year, and investors can mitigate the effects through simple techniques such as dollar-cost averaging, diversification, investing in relatively recession-resistant sectors and focusing on the long-term.

The market also seem to be picking back up at the point of this writing. Inflation also seemed to have peaked. Now the ball is back in the Fed’s court to do the necessary and not overkill the economy.