How to prepare for a bear market

No matter how much you’d like to avoid it, if you have investments in the stock market, at some point you are going to have to confront the “B” word – bear, as in a bear market.

The term sends a shudder down the spine of investors who worry that all their hard work and portfolio gains could be wiped out overnight. This fear often causes investors to panic and make rash short-term decisions, the type that can do more damage to their financial future than any bear market.

So the question is, how do you prepare for a bear market?

First, let’s start by defining our terms – because there are a lot of misconceptions about bear markets and what they really are.

The definition of a bear market is when securities drop 20% in value from their recent highs. Generally speaking, the S&P 500 is the benchmark for market performance. So when that index is down 20%, it is usually considered a bear market.

But that 20% number is arbitrary. It’s not like a group of economists got together and decided that 20% was a bear market. In fact, nobody really knows who came up with that 20% number. It’s just a generally accepted number, but there’s no hard-and-fast rule that says a 20% is a bear market.

And because financial markets aren’t monolithic, neither are bear markets.

For example, you could have one market sector hitting all-time highs, while another might be down 20% or more. It’s the same with asset classes. One asset class, such as stocks, could be in a bull market, while another, such as commodities, could be in a bear market.

You could also have a scenario in which tech stocks are weak and a tech-heavy index like the Nasdaq composite might drop 20%, while another index like the Dow Jones Industrial Average never gets into bear territory. Sometimes this is referred to as a “stealth” bear market because even though the S&P 500 may not be down 20%, an investor’s portfolio could be down 20% (or more) if it’s overweighted in a certain sector.

Another important thing to know is that despite being painful in the short term, bear markets are part of the stock market cycle, they don’t last forever, and even though past performance won’t guarantee future results, when they’ve happened in the past, the market has always recovered – and moved higher. Here’s some historical context that might help ease your mind as you prepare for a bear market to happen:

• Bear markets occur regularly. There have been 26 bear markets in the S&P 500 since 1928. But there have also been 27 bull markets – and stocks have generally risen over the long term.
• Bear markets tend to be short-lived. The average length of a bear market is 289 days, or about 9.6 months. That’s significantly shorter than the average length of a bull market, which is 991 days or 2.7 years.
• Bear markets have been less frequent since World War II. Between 1928 and 1945 there were 12 bear markets, or one about every 1.4 years. Since 1945, there have been 14 – one about every 5.4 years.
• Stocks lose 36% on average in a bear market. By contrast, stocks gain 114% on average during a bull market.
• Most importantly, half of the S&P 500’s strongest days in the last 20 years occurred during a bear market. Another 34% of the market’s best days took place in the first two months of a bull market – before it was clear that a bull market had begun.