Investment Strategies In a Bear Market
Stocks in a Bear Market – So what do I do now?
It is true – the stock market, as measured by the S&P 500, is in a bear market. What does that mean? A bear market is defined as a decline in the S&P 500 Index of 20% or more, which is what we have recently experienced. Inflation, rising interest rates, the war in Ukraine, the lockdown in China due to their Zero-COVID policy, and global recession fears have all contributed to the decline in stocks this year. Bonds have not fared much better, declining 10% year-to-date as measured by the Aggregate Bond Index. If we were to close out the year today, it would be the worst annual decline in bonds in over 80 years, with the previous worst annual return down 3%1.
So where do I put my money?
First of all, don’t panic. We’ve been here before. It’s important to understand what your current allocation to various investment assets is. Are you allocated 100% to stocks, 100% to bonds, or somewhere in between? Take a step back and think about your financial and life goals. If you’re young and just getting started in investing, you have a longer time horizon and can weather the ups and downs of a typical market cycle. If you’re nearing or in retirement, you may be concerned with preserving your principal investment and are less willing to risk your assets. In any case, it is important to have a diversified portfolio, no matter what your overall allocation is to stocks and bonds.
What types of investments should I have in my portfolio?
If you’re young and just starting out, you’ll want to be more heavily weighted in stocks. Stocks are riskier assets but offer the greatest return over time. A good habit to get into is putting some money aside every paycheck, so that if the stock market declines you are buying as the market goes down. It may feel stressful in the short-term, but over the long-term you will be glad you did.
Growth vs. Value
Within your stock allocation, it’s important to have a mix of growth and value stocks. A growth company is one that is expected to grow its revenue faster than the market average. Many technology companies are considered growth companies because they are leaders in innovation and are often newer companies with a lot of room to grow. Growth stocks can be risky because they tend to gather momentum as investors bid the price of their stock up, and expectations for growth are high. If earnings disappoint, growth stocks tend to get hit harder than value stocks.
Value companies are companies that look to be undervalued on a price-to-earnings basis. They may be trading at a discount due to disappointing earnings, management issues, negative publicity, or depressed conditions within the industry. Value companies tend to be more mature, established companies that pay a good dividend. Value stocks tend to hold up better in a down market because the expectations for growth are lower. They also tend to do better when interest rates are rising. Many financial and energy stocks are considered value stocks.
U.S. vs. Foreign
It’s also important to have a mix of U.S. and foreign stocks in your portfolio. U.S. investors tend to focus on U.S. companies because they know them better, and over the last 11 years that has worked well. But there are periods of time when foreign stocks perform better than U.S. stocks, so it’s important to have some exposure to foreign stocks in your portfolio. Foreign stocks have been trading at a discount to historical valuations for some time now, which may create investment opportunities in your portfolio. There are 2 main categories of foreign stocks – developed and emerging markets. Developed foreign stocks represent countries that are more established, have a strong infrastructure and a relatively high standard of living. Examples of foreign developed markets are the U.K., Japan, Canada, and France. Emerging market stocks represent countries that are experiencing rapid growth but are less stable than developed countries and therefore riskier. With that risk comes the potential for higher returns over time.
As you get older, it is important to add some bond exposure to your portfolio to protect your principal. Bonds also provide a steady stream of income from interest payments. As we have seen in 2022 so far, positive returns on bonds are not a guarantee, but historically bonds have provided positive investment returns in most years and have acted as a buoy when the stock market declines. When stocks decline, money typically moves out of stocks and into bonds. But with interest rates rising, investors have been hesitant to put money into bonds because if interest rates continue to go up, that makes their bonds less attractive to buyers. As a result, bond values go down as interest rates rise.
Much like stocks, it is important to have a mix of different types of bonds in your portfolio. U.S. Treasury bonds are backed by the full faith and credit of the U.S. government, making them a relatively safe and popular investment. Treasury Inflation-Protected Securities (TIPS) are bonds whose principal is adjusted based on changes in the Consumer Price Index (CPI), and tend to do well when inflation expectations are high. Corporate bonds are issued by private and public corporations and are typically considered investment-grade or high-yield. Investment-grade corporate bonds have a higher credit rating, implying less credit risk, whereas high-yield bonds offer higher interest rates in return for increased risk. Municipal bonds are issued by states, cities, counties, and other government entities, and provide tax benefits in after-tax accounts. The interest from municipal bonds is exempt from federal income tax and may also be exempt from state and local taxes for residents in the states where they are issued.
It is also important to have cash set aside in an emergency fund. The rule of thumb is enough to cover 3 to 6 months of living expenses, although some investors may wish to hold more than that for peace of mind. This cash should be invested in short-term instruments such as money-market or certificates of deposit.
Determining Next Steps
How you allocate your investments depends on your capacity and tolerance for risk as well as your goals and time horizon. It’s important to be able to sleep at night, and for some investors that means reducing their exposure to risk assets such as stocks. Having a well-diversified portfolio between U.S. and foreign stocks, as well as a broad range of bonds instruments, will go a long way towards reducing the volatility in your portfolio while providing consistent returns over time.
Don’t forget to rebalance your portfolio at least once a year to keep your allocations in line with your investment goals. It is likely that you are underweight stocks and overweight bonds due to stocks declining more than bonds over the last 6 months. It is also likely that you are underweight growth stocks relative to value stocks given the recent underperformance in growth stocks.
A bear market is never fun to live through, but there are plenty of adjustments that can be made during times like these. After a year like last year when the stock market seemed to go up just about every day, valuations got extended and have since corrected, and then some. This is a good time for a financial check-up. You may have decided that you don’t want as much risk in your portfolio, or you may have realized that you’re closer to retirement than you previously thought. You may see this as an opportunity to increase risk and add to your stock allocation. Review, rebalance and try to relax. We’ve been here before and we will get through it again.
If you need help determining your tolerance for risk or how to allocate your portfolios to match that tolerance, you may want to consider meeting with a financial advisor that can help determine what your next steps should be for this market and beyond.
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