There’s a lot of chatter circulating right now that we may be entering a bear market.
After nearly nine years of an unprecedented bull rally, we’re finally beginning to see signs of real fear from investors, so it’s time to talk about some strategies for hedging, and even profiting, during times of market decline.
Before we get to that, here’s a quick recap of the week.
On Monday, the Dow Jones Industrial Average (NYSEARCA:DIA) closed down 1,175 points, marking the biggest single-day points drop in history. The S&P(NYSEARCA:SPY) shed 4.1% on the day. The CBOE Volatility Index, also known as the “fear gauge,” spiked 115% to its highest level since 2011.
The talking heads were quick to dismiss Monday’s plunge as nothing but a correction, but stocks remained volatile throughout the week, and by Thursday afternoon the Dow was down another 1,032 points, or 4.15%. The Nasdaq (NYSEARCA:QQQ) Composite and S&P 500 were not far behind on a percentage basis.
While not quite a crash by definition, there’s no doubt this week’s action has signaled reduced investor confidence and a less stable market than what we were looking at coming into 2018. And although it’s generally a mistake to be reactionary as an investor, it’s never a bad idea to be cautious.
That said, here are five important rules for protecting yourself in a shaky market like the one we’re seeing play out today.
Rule #1: Don’t Throw Your Hands Up
When stocks start to sell off, novice investors will often get spooked and turn their backs on the market entirely. This usually turns out to be a mistake because of lost opportunity down the line.
To start, you can never know for certain if what you’re dealing with is a correction, crash, or trend reversal until after the fact. If you’re fearing a crash but end up selling on a correction, you’re going to be missing out on the rally that follows.
Money you could have made but didn’t is, for all intents and purposes, money lost.
In fact, some of the best profit opportunities appear when markets sell off because stocks are effectively on sale. Not to mention, there are a number of assets and vehicles that perform just fine during periods of broader market decline (more on this below).
Rule #2: Go Heavy on Cash
When bear markets emerge, cash is king. This may seem contrary to Rule #1, but there’s a difference between avoiding the market altogether and keeping funds on hand while you search for deep discounts.
In times of broader market decline, selling is widely indiscriminate. This creates flash sales, particularly on companies with solid fundamentals and outlook. The mantra “buy low and sell high” applies to these kinds of defensive stocks more than any other asset.
In brief, bear markets are a great opportunity to build stake in long-term value stocks, so you’ll want to keep cash on hand to nibble at those assets as they move down. Dividend-paying companies with strong balance sheets and healthy margins are especially important to keep an eye on.
Rule #3: Reallocate to Reduce Risk
Transitioning to cash is just one piece of the broader allocation puzzle. When markets are uncertain, you can reduce risk by spreading your bets across a wider range of industries and vehicles.
Generally speaking, you want to find assets that are either uncorrelated or inversely correlated with stocks.
Cash, for instance, is not tied directly to the market and thereby presents little risk to investors aside from inflationary risk. To hedge against that risk, investors should consider exposure to assets that defend against inflation such as gold, commodities, and real estate.
You also have assets that tend to move in the opposite direction of stocks. Short-term debt securities, namely short-term Treasury Bills, can help stabilize your portfolio and protect against losses.
Investors can easily gain further exposure to liquid short-term debt securities by adding funds like SPDR Barclays Short Term Corp Bd ETF (NYSEARCA: SCPB), Guggenheim Enhanced Short Dur ETF (NYSEARCA: GSY), and iShares Short Maturity Bond (BATS: NEAR).
Rule #4: Keep Your Emotions in Check
It’s easy to get wrapped up in panic-inducing headlines when stocks dip, but getting worked up and emotional about market movements is one of the worst things you can do as an investor. Always try to be aware of your emotions and be sure they aren’t guiding your decisions.
It helps to come to terms with the fact that, as a general rule, you can’t successfully time the market. There’s always a delay between when an event occurs and when you find out about it, so by the time you find out about a crash (or any other event), the opportunity to sell high has already passed.
In fact, money flow analysis over the last 30 years shows that net outflows peak at market bottoms, while net inflows peak at market tops. In other words, investors tend to buy and sell most at exactly the wrong times.
To use one of the most quoted pieces of investment advice out there, you need to be fearful when everyone else is being greedy and greedy when everyone else is being fearful. You can’t make money in the market as a follower; you have to lead the trend.
Rule #5: Put in Your Stop Losses (But Don’t Rely on Them)
A stop-loss order is an order you place with your broker to sell a stock the moment it reaches a certain price. You can keep these orders in effect for an extended period to limit your losses in case you’re not paying close enough attention.
Where exactly you put your stop losses is going to depend on what you’re willing to lose, but it’s generally recommended to place a trailing stop-loss percentage of 15% to 20%. A trailing stop means your position will automatically be sold once it’s down X% from its peak price.
Stop losses, however, are not infallible. If a stock gaps down, a stop-loss order can be triggered at the next best available market price, which could be many points lower than the triggered selling price. This is the downside to a stop-loss market order.
A stop-loss limit order, on the other hand, will only fill your order at the stop-loss limit price or better. That means you won’t sell at a lower price, but it also means you’re stuck holding the bag if there were no orders to fill your position.
Fortunately, this will only occur if a stock gaps down, which is a rare occurrence. Despite their limitations, stop losses are an incredibly useful tool for limiting your risk.