The investing world's jargon is sometimes too colourful. For example, there are "bull markets," or periods in which a particular type of investment does exceptionally well. Less pleasantly, there are "bear markets," or times when a particular type of investment performs poorly.
Now if only we knew when those bears would roar, or what investments would survive the mauling. But because each slump brings its own new twists, yesterday's bear-market hero may not survive the next downturn nearly as well. Besides, even if bear-proofing a portfolio were simple, it may not be smart.
A bear is not a bear is not a bear
Over the past 30 years, the
FTSE 100 index has slid considerably a handful of times--the recent
recession being just one example. Though each bear attacked in different
ways, but there have been some common themes. Technology funds and
natural-resources funds, for example, have been struck repeatedly. On
the other hand, income-oriented utilities and investment-grade bond
funds typically escape major trauma. Everything else has been less
predictable. Small-company funds held up well during one bear market,
and then suffered during the next one. Junk-bond funds have wandered all
over the map, posting gains in the early bear markets but collapsing in
1990 as the economy weakened and stumbling again from 2000 to 2002 amid
a spate of downgrades and defaults in the energy, cable and telecom
areas. Gold
has also been mixed: Anyone who came out of the late-1970s bear market
believing gold was the place to be on a long-term basis got burned in
the early 1980s, when the bear knocked precious-metals funds for a 30%
loss. In recent years, however, gold has provided a haven for investors
fearing inflation and geopolitical instability. In the new century,
cautious investors have flooded the precious-metals category, with gold
hitting an all-time high last year well above $1,000 per Troy ounce.
Three varieties of bear
Many different causes can trigger a bear market, but usually the cause
has something to do with the economy. Here are three common causes of
bear markets, as well as what types of investments tend to do best in
each type of bear market.
Recession: As we all know, the British economy has until recently been deep in recession. Not only did consumers tightern their purse strings and stock prices tumble, but business spending—the lifeblood of growth for many new economy names—slowed to a halt as companies pared back their budgets.
Firms that deliver inexpensive or staple products, such as food, beverages, cigarettes, and health-care items, tend to do well in a recessionary environment, though they may well experience their customers trading down to cheaper alternatives. Other stocks, such as automakers, steel producers, and paper manufacturers, are highly sensitive to economic cycles—hence they are termed cyclicals. Such stocks pop up most often in value funds. High-yield (or junk) bond funds can also be risky when the economy sours.
Rapid inflation: From the 1960s through the 1980s, many investors viewed inflation as a given. Not even common stocks could protect investors from the price increases of the late 1970s. During normal circumstances, large-company stocks will provide an annual return that outpaces inflation over the long term, but during the inflationary 1970s, even those stocks couldn't keep up with Treasury bills.
Deflation: After the late-1997 troubles in Southeast Asian economies, deflation became the economic worry du jour in the United States. Pundits speculated that a flood of cheap Asian imports would force US companies to lower their own prices, sparking a general fall in the US Consumer Price Index—or in other words, deflation. That situation hadn't occurred since the Great Depression in the 1930s, when overall prices declined by as much as 10% in a single year. For a variety of reasons, deflation makes it more difficult for businesses to grow their profits, thus weakening stock prices.
Long- and intermediate-term bond funds tend to hold up relatively well in this environment, because their dividends are effectively worth more in this type of economy. A 6% dividend delivers more purchasing power each year if prices are falling by 2% annually. Among equities, look for dividend-rich stocks and the funds that own them. What suffers? Inflation-indexed bonds, non-dividend-paying stocks, and anything tied to a real asset such as gold or real estate do poorly in a deflationary environment. Remember, deflation means a decline in the prices of tangible assets.
What to do
Preparing for a bear market is clearly a vexing problem, given the
variety of bears. Here is what we think:
Don't try to time the market by switching to cash: Anyone who tries to trick the bear by selling investments and piling up cash will likely suffer less-than-perfect timing and miss out on big stock-market gains. Unless you know something we don't or are extremely lucky, you won't get rich playing the timing game.
Recognise the limitations of bonds and gold: Given that utilities and bond funds have evaded the bear in a number of situations, they might be decent shelters. There are some caveats, though. For one, tucking too much money in these bear-market champs is a good way to avoid bull markets, too. During the bull market of the 1990s, bonds and utilities didn't return nearly as much as diversified domestic-equity funds did.
Moreover, these funds aren't completely bulletproof. For starters, being better than everyone else isn't the same as being good. Bonds may have been the best thing going in 1990, but they still lost money as the Persian Gulf crisis unfolded and interest rates spiked. Also, keep in mind that these funds do endure their own separate bear markets from time to time; investors learned that the hard way in 1994, when utilities funds plunged 9% in an otherwise flat market.
Be wary of committing to bear-market funds: An alternative to bond and utilities funds are funds designed specifically to battle the bear, called bear-market funds. These funds typically bet against stocks by shorting stock indices or individual stocks. However, remember that bull markets won't likely be kind to these funds. It's also worth noting that stocks have increased in value over long periods of time, and bear markets tend to be relatively brief in historical terms. Using a bear-market fund effectively requires that you be able to predict when the market is going to head south, and few, if any, investors have shown any ability to do this consistently.
Grin and bear it: Let's face it--investing has its risks, one of which is losing money. It's going to happen from time to time. Diversifying across a variety of fund types and asset classes won't prevent the blow, but it will soften it. Every bear leaves at least a few fund categories with relatively minor injuries.
After setting up a diversified portfolio that meshes with your long-term goals, the best plan is the most obvious one. Stay the course, invest regularly, and promise yourself not to panic when (not if) the market stumbles. The prospect may seem unappealing, but the alternatives can be worse.
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