What to do & not do when the stock market is falling
A Bear market is a period when the major market indexes like the S&P 500, TSX & FTSE 100, fall by 20% or more. The S&P500 has fallen more than 20% from its high of 4818 & the NASDAQ is down more than 20%. But the TSX Composite Index is down by almost 1400 points, and not in bear market yet.
Bear market periods are usually filled with tension, pessimism and low inventor confidence. Some investors would continue disposing off their stocks thus bringing the prices lower.
A Bearish market could be caused by economic recession, inflation, interest rates, and socio-political issues. There have been 17 Bear Markets for the S&P 500 since WWII and it recovered from all of them.
It is important to understand that bear markets eventually give way to Bull markets but while you wait, you need to keep investing but with more caution.
Types of Bear markets
- Cyclical – triggered by a weak economy, hike in interest rates & inflation.
- Structural- triggered by financial bubbles like the 2008 financial crisis
- Event-driven- triggered by conflict, pandemics etc.
Some notable Bear Markets in history
- Black Wednesday September 1992. Britain: Caused by the withdrawal of the British Pound from the ERM mechanism and the loss was £3.3 billion
- Black Monday- Oct 1987. USA: The Dow Jones industrial Average and S&P500 fell 22.61% and 20.47% respectively in one day. The crash was mostly caused by High Frequency Trading caused by panic. It lasted about 2 years. Global loss was about US$1.71 trillion
Investing during a Bear Market
A bear market is not the end of the world and so you don’t have to stop investing. There are still ways of riding the wave as you just need to be more careful.
In 2009 when the scars of the 2008 financial crisis were still fresh, Warren Buffet bought shares in blue-chip companies such as Goldman Sachs, the Burlington railroad, Mars etc. The investment paid off for Warren Buffet as he has reportedly made $10 billion from investing during the crisis.
He looked to the future and understood that the bear market would end. Investors should think long term & see stocks as ‘ownership’ of companies rather than short term buy & sell.
Here are some tips that you could follow.
1. Maintain a Backup fund
Ensure you have some funds that will be there to meet your most essential and emergency needs. Don’t make the mistake of investing with your house rent money or children’s school fees.
Your backup fund could be warehoused in low hanging, easy to reach instruments like fixed deposits so that you can earn some interest no matter how little.
If you have saved enough money, you might even be able to buy up some value stock at a discount and benefit from it later.
You should take note that Bear markets, no matter how temporal, could be financially demanding. It is very advisable that if you are investing in this period, don't invest money you can't afford to lose.
2. Avoid Short Selling
Short selling is a method experienced investors use to benefit from falling stock prices. There are two popular ways to short sell and they are:
- Borrow the shares from your stock broker
- Enter a Contract for Difference (CFD) with a Duly Licensed CFD Broker
Firstly, borrowing stocks from your stockbroker means you lend the stocks and sell at the current market price. You then wait for the stock price to fall, then you re-buy and return it to the broker. Your profit is the difference between sell and buy prices.
Secondly, you could pick a broker that offers CFDs on an index and take a short position on the index if you think the market is going to go down, while the broker or the counter party takes a long position. If the price of the index falls, you make the win and the broker or the counter party pays you the difference.
For example, you could trade NASDAQ as a CFD instrument.
This is a derivative product, so you don’t own actual shares or the index while trading CFDs. There are 170+ IIROC regulated dealing members, and as per this research of best forex brokers in Canada some of these brokers offer CFD trading on major Indices like .
But shorting any other market as a CFD instrument can be extremely risky if you are leverage because when you go long (BUY) by actually buying a stock without any leverage, the only risk you face is the price of the stock falling to zero as it can’t fall past zero. However, when you short sell, the risk you face is that the price of that instrument can keep rising. So, your loss could be unlimited & can easily wipe out your capital.
Thirdly, you can buy into Inverse ETFs. An inverse Exchange Traded Fund (ETF) is a fund created using derivatives that profit from the decline in the market or a specific index. By buying an Inverse ETF, you let the fund managers do active management.
3. Hedge Risk with ‘put option’ contracts
To simply put it, a put option is a contract that gives you the right (not obligation) to sell a specific number of securities for a predetermined strike price at a predetermined date
Put options can be used if you expect the option's underlying asset (e.g., Stock) to decline in price during the period of a Bear market.
Example if you have bought 100,000 shares of TSLA at $707.73 today, and you fear the price may fall one month from now you can do this:
Approach your stockbroker and buy a Put option that gives you the right but not the obligation to sell 100,000 shares of TSLA to the option writer at $707.73 one month from now.
By doing this you have locked in today’s price for tomorrow. It’s also important to note that you will have to pay a Premium to the option writer to buy the put option contract. These premiums can be high depending on the chances that your prediction may be right.
If you’re right and TSLA falls in price, you are protected as you can exercise the Put Option and sell TSLA at $707.73. Your only expense is the amount you paid for the premium.
However, if you’re wrong, and TSLA rises in price it will make no sense for you to sell at a loss. Since the contract doesn’t oblige you to sell, you can walk away from the contract but forgo the premium paid.
4. Diversify your Portfolio
Diversifying has to do with equipping your portfolio with different asset classes. The reason behind diversification is that when one asset class or sector is underperforming, the other ones should make up for it. Your portfolio should contain the following:
- Defensive Stock- There are some companies that deal in essential products. During bear markets, some stocks of companies that produce items such as consumables goods, food items and healthcare firms are good places to turn your attention to.
- ETFs (Exchange Traded Funds) – ETFs take funds contributed by investors and buy various assets. Some ETFs focus on indices, some on Bonds, currencies etc. The point is ETFs ensure you don’t have to bother about handpicking individual stocks as the fund managers do the work for you.
For instance, buying into an ETF that tracks the FTSE 100 means you have bought shares in all the 100 companies the index is tracking.
- Government Bonds/Gilts: When you buy a government bond, you have lent your money to the government and will be paid interest semi-annually, annually or at the end of the contract. Your principal is also refunded upon contract expiry.
Government Bonds are low risk because the possibility that the government will default is nearly zero. Bonds, however, don’t pay interest high enough to beat inflation but they are ideal for safety.
If you plan to retire soon, bonds are also a way to go. Some have tenors for as long as 20 years meaning you will be earning interest for that period.
- High Yield Dividend Stocks: Dividend stocks are a good opportunity during a period of the bear market because they have to do with the company's net income; while market traders are the ones that determine the movement of stock prices.
When the stock prices fall, you can still be earning your returns as long as the company still makes profits.
5. Take some profits when they come
Even in a bear market, prices of stock still rise momentarily so don’t hesitate to sell and make a profit. However, you should endeavor to re-invest the profit into buying more stock and diversifying more.
In fact, if you keep on Investing during the period when prices are declining, the strategy could pay off later. You may buy stocks at a discount and after a market recovery, your investments would increase in value.
You can use different strategies to navigate your way during a bear market period and even deploy the situation to your advantage.
Being in a bear market doesn't mean that all your money would go down the drain. Even during the longest bear market, some firms and individuals scaled through. So, during unfavorable market behaviors, do your research & consult your financial advisor and stick to your investment plan.