Many investors like to consider of themselves as long-term investors, or at least characterize themselves as such.” Their goal is to stay fully invested through thick and thin. The majority of institutions do the same thing. However, such a rigid approach can have disastrous consequences, particularly for individual investors. Individuals and institutions may be able to sit out relatively mild (25% or less) bear markets, but many bear markets are not. Some, like 1973-1974, 2000-2002, and 2007-2008, are downright disastrous.
The Illusion of Buy and Hold
The difficulty always arises at the start, when you begin to detect an imminent bear market. In most circumstances, it is impossible to predict how severe economic conditions will get or how long they will last. The Vietnam War, inflation, and a constrained money supply all contributed to the 1969-1970 correction becoming a 36.9% two-year fall. Prior to that, bear markets lasted an average of nine months and dropped the market by 26%.
During a bear market, most stocks decline, but not all of them recover. Holding on during even a minor bear downturn might leave you with damaged merchandise that may never see its former highs. When the overall environment changes and your stocks are not performing well, you must learn to sell and raise at least some cash.
During the 1980s and 1990s, buy-and-hold investors fell in love with Coca-Cola. Year after year, the soft-drink behemoth traded up and down with the market. However, it stopped working in 1998, as did Gillete, another long-term favorite. When the market fell into a moderate bear market that summer, Coke followed suit. Coke was trapped in a decline two years later, despite some of the market’s most exhilarating advances in decades. This type of stock may return in some cases. But one thing is certain: Coke investors missed out on big gains in companies like America Online and Qualcomm in 1998 and 1999.
Tech Bubble Burst: Lessons Ignored
Anyone who owned technology equities from 2000 to 2002 was also a victim of the buy-and-hold approach. Many high-fliers lost 75% to 90% of their value, and some may never regain their previous highs. Consider Time Warner, Corning, Yahool, Intel, JDS Uniphase, and EMC, which were industry leaders from 1998 to 2000.
How to Protect Yourself from Market Downturns
Swift Action: A Key to Survival
Napoleon once stated that never hesitating in battle gave him an advantage over his opponents, and he was unbeaten for many years. There are the swift and the dead in the stock market’s fight!
Don’t hang around when you observe the first few obvious signs of a market peak. Sell immediately before true weakness emerges. When market indexes reach their peaks and begin large downward reversals, you should move quickly by putting 25% or more of your portfolio in cash and selling your stocks at market prices. Limit orders (buying or selling at a specific price rather than at market prices using market orders) are not recommended. Concentrate on your abilities to enter and exit a stock when necessary. Quibbling over an eighth- or quarter-point (or their decimal equivalents) may cause you to miss out on a stock purchase or sale.
Evolving Strategies for Turbulent Times
In the end, there are really only two options when a new bear market begins: sell and retreat or go short. When you withdraw, you should do so until the bear market ends. This is frequently five to six months or more. However, in the protracted, troubled decades of 1969-1970 and 1973-1974, it meant up to two years. The bear market that began in March 2000, during the Clinton administration’s final year, lasted far longer and was significantly more severe than usual. Nine out of ten investors suffered significant losses, particularly in high-tech firms. It marked the conclusion of a decade of numerous excesses in America, a decade in which the country became irresponsible and let down its guard. Stocks were running wild during the “anything goes” period.
If your stock account is on margin, lightning-fast action is even more crucial. If your portfolio is completely margined, with half of the money in your stocks borrowed from your broker, a 20% drop in stock price results in a 40% loss. A 50% drop in your investments might bankrupt you! Never, ever attempt to ride a bear market on margin.
Short selling can be successful, but be warned: it’s a difficult and highly specialized talent that should only be undertaken during bear markets. Few individuals make a living from it.