Stock market downturns are inevitable. No matter what happens we are at one point or another going to experience a bear market. In this article I am going to explain to you how to deal with one and take advantage of it.
First let’s check out what is a bear market and what is a correction.
Stock market correction is when the main index (for example S&P500) is down 10% or more from its all-time highs. Corrections last 4 months on average and take 3.7 months to recover. The average market loss in a correction since WWII is 13.2%.
Bear market is when the main index (for example S&P500) is down 20% or more from its all-time highs. They last 13 months on average and take on average 21.9 months to recover. The average market loss in a bear market since WWII is 30.4%.
Corrections are usually easy to handle as the losses are not very big and they usually rebound very quickly. Bear markets on the other hand can lead to stock market crashes, which can be very tough, especially on beginner investors.
Stock Market Crash History
The Great Depression of 1929
As you can see this is the biggest crash in the history of the US stock markets. It was also one of the deepest depressions in history. The markets have dropped massive 89% and it wasn’t until 1954 when the Dow Jones have achieved new all-time highs. That is 25 years before you see any returns on your money if you invested at the peak of 1929.
What Caused It?
If we have to describe it with one word it would be overconfidence. The period from 1921-1929 is known as ”The Roaring Twenties”. During this time the stock market increased with 20% on average, margin loans have been easily accessible and people have been taking on more and more debt. At the peak of the bubble banks have been giving out margin loans for as little as 10% of the share value.
What that means is for example if you want to buy $10,000 worth of stock you can put down only $1,000 and the margin loan would cover the rest. What has been even worse is that those loans have been given out to people with little to no understanding of the stock market.
Eventually the market collapsed and all those people started defaulting on the loans. That led to panic and the stock market started falling, bank bankruptcies have followed and the panic has spread resulting in the great depression.
That is of course a very simplified version of the whole thing, the causes for the depression itself have been much more complex, but here we are focused on the stock market crash.
Bear in mind that back then the stock market has not been as regulated and such a drop of almost 90% is highly unlikely to happen again. There have been a lot of measures to prevent such wide-spread panic from happening again.
Stock Market Crash of 1987
This is the biggest one-day % drop in the history of the S&P500 with a little over 20% loss in a single day. It has been cause by the rise of the trading algorithms. This is when computers are programmed to buy or sell stocks when certain criteria is met.
When the market started dropping all the algorithms started selling shares and that caused a snowball effect causing the market to drop more than 20% in a single day. This day is also known as ”Black Monday”.
Since then there have been certain regulations placed in the stock market to avoid algorithms selling so much shares so quickly.
Still despite that massive one-day drop the markets have recovered fairly quickly. The S&P500 have reached new all-time highs less than 2 years later.
The Dot-Com Bubble of 2000
This was the second biggest speculative bubble after 1929. As a result the NASDAQ index fell down by 76% from its all-time highs. The market needed 15 years to recover those losses.
What caused it was similar to 1929 – overconfidence and speculation. With the rise of the internet every company connected to this new industry have seen crazy valuations and people have not been very concerned about fundamentals. Once that the bubble popped people started panicking and selling their shares.
That led to this big crash and a lot of those internet companies went bankrupt. There are a lot of companies, which are yet to reach their all-time highs achieved almost 20 years ago. Intel, Qualcomm and Cisco are some examples.
Financial Crisis of 2008
Most of you probably remember the financial crisis of 2008. It was a very rough downturn, especially on the banking sector. There are still a lot of banks, which cannot recover from their peaks of 2007/8.
It was caused by once again overconfidence and greed. Long story short banks have started giving out mortgages without doing any due diligence. That led to people who could not afford home buying homes on loans. Then all those people started defaulting on those loans resulting in the bankruptcies in financial institutions.
It resulted in a drop of more than 50% in the S&P500 and companies such as Lehman Brothers and General Motors declared bankruptcy.
It took a period of 6 years for the S&P500 to recover and reach new all-time highs.
What Do All Those Have in Common?
Ok we have gone through the toughest, most severe market crashes of the last 100 years. Now let’s think about what do all of those have in common. First we can see that they are all fueled by greed(speculation) and go down on fear(panic), which shows us that non of those is a friend of the good investor.
What is more important though is that they all inevitably go back up to new all-time highs. Yes we are inevitably going to have a crash at some point in our lives, but we are also inevitably going to go to new all-time highs.
If there is one key takeaway from all this it is that you should avoid emotions in the stock market and that you should think long-term. Avoid picking companies based on hype and greed, pick companies based on fundamentals and you are going to be fine.
Beginner Tips for Navigating a Stock Market Downturn
1. Exit Your More Speculative Investments.
Im talking your super high p/e growth stocks which pay no dividend. A lot of those companies have a very hard time during recessions. They usually need a lot of funding and debt to grow and in those times this is harder to get.
Usually appettite for risky investments is very low in a downturn and those kinds of stocks are getting hurt really badly.
For example if you invested in Cisco in 2000 you are still going to be down on that position. If you take into effect inflation and lost opportunities you are actually significantly down on such position. And just to be clear Cisco is a fantastic company, I am using it as an example of how greed can affect your returns, even when you invest in solid companies.
2. Keep Some Cash on Hand
Having cash on the side during market downturns can be a fantastic opportunity. During those times you can buy companies at 30,40,50%+ discount. That is why it is important to have some cash, otherwise you will not be able to take advantage of those opportunities.
What I advice you is to keep around 10% of your portfolio in cash. This way you always have chance to react to good deals in the market. Sometimes you can go as high as 30-40% cash, but most of the times this is not optimal. Only do this if you cannot find good deals in the market.
3. Dollar-Cost Average Into The Market
So what does that mean? That means that instead of investing all your savings at once you start doing that gradually every month. For example you have $10,000 and you want to start investing. Instead of dumping them all at once you are going to invest them at let’s say at portions of $1000 a month. It is easier said than done because requires discipline, which a lot of people lack, but it will help you a lot, especially investing in late stages of a market cycle. That way you are going to buy stocks all the way down which helps to drive total returns higher going forward.
4. Invest in Dividend Stocks
Stocks which pay a dividend tend to be more stable and not so volatile during a bear market. Of course there are some exceptions , but in general that is the case. Stick to big renowned companies which have increased their dividends for many years like the Dividend Aristocrats for example – stocks which have increased their dividend every year for the last 25 years. These are some stocks who have been through a lot of economic downturns and still managed to increase their dividends. Also getting paid a dividend every quarter helps you not to worry about the price of the stock so much and sleep well at night. Especially if that dividend is increasing every year.
5. Invest in Companies With Less Debt
You might have noticed a similar pattern in the companies going bankrupt during the past market crashes. It is that they always had big amounts of debt. When the economy goes down their earnings decrease. If the debt is too big they are not able to repay it with those lower earnings. So what happens is that they default on their debt and that is never good news for the shareholders.
That is why it is important to invest in healthy companies with manageable amount of debt.
6. Invest in Companies That You Believe in
Usually when we buy a stock we buy it for the long term, but our mind can change if we see that stock down let’s say 50% with a bunch of bad news coming out every day that make us question our choice. It takes some strong mentality to ignore everything and continue buying with all that uncertainty around the stock. That is why you should know the business you are investing in very well and know why you invest in it. If you have that in mind at all time it would be much easier to ride that downturn and even take advantage of it.
But if you invested in a stock just because someone told you to do so then you can be in a very tricky situation in the downturn. You see all those negative news all around you and you decide to sell just because you are not sure what to do. You will not be the first person who has done that and will definitely not be the last, but try not to be that person at all.
7. Do your Research
If you do a good research and are confident in your picks there is nothing to worry about. As long as you have picked healthy companies with good management you are going to be fine.
Having a well-diversified portfolio also helps. More diversification means less risk, especially if it is across different asset classes. Holdings some gold or bonds can help to offset your losses.
8. Make a Watchlist
Watchlist is basically putting a couple of companies under a closer look. My advice to you is to make that watchlist when the market is high and the stocks are too expensive. Choose your favorite companies that you want to invest in, but are too expensive at the moment.
My idea is that when a market is going down it is a bit harder to actually put your money in companies. The markets do not go down for no reason and in a market crash the sentiment around you is going to be bad. That is why it is a good idea to make a watchlist when the sentiment has been good. It is kind of like a message from you to yourself.
9. Ignore the Noise
This is maybe the most important tip I can give you. When the market is going down all the media is going to talk about how the sky is falling and this is the end of the world as we know it. Of course they are getting higher ratings this way and they have interest to say that.
The problem is that if you keep listening them every day sooner or later you will start thinking that the world is indeed falling apart and there is no coming back. As we learned so far if there is one thing for certain is that the stock market always recovers sooner or later. That is why the less you listen to all the media the better for you.
10. Be Careful With IPOs
Usually a lot of IPOs is a good sign of a peaking market cycle. What happens is that all the insider investors want to cash out some of their investments. The best time to do this is when optimism is high, getting capital is easy and valuations are high. All those are happening late in a market cycle.
Now I am not saying not to invest in IPOs at all, but I woul be extra careful. First it is a good idea to wait for the IPO a couple of months and see how the price moves. Wait a couple of earnings reports and see how the company is doing. A bit of patience can pay off when making such decisions.
Conclusion
If there is one key takeaway from this is that the markets are inevitably going to go through a crash. But they are also eventually going to go back up. What we can do in the meantime is take advantage of all the discounts we are given and adjust to the market conditions. Keep your emotions out of the markets and you are going to do well.
Hope that was helpful to you in dealing with the next bear market. Don’t forget to subscribe if you want to stay updated on upcoming articles.