Every market has its share of bearish investors who expect bad things to happen.
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Fortunately, those who think stocks are ready to fall in price have some good investment options for riding out bad markets and prospering in good markets. They can turn to high-quality defensive stocks or corporate bonds to build a relatively safe portfolio. Or they can invest in unconventional mutual funds such as so-called contrarian funds that buy beaten-down stocks or riskier inverse exchange-traded funds that bet against index gains.
If your personality fits the bearish mentality, investment professionals offer several investing options you can consider to follow a risk-averse strategy.
These days, there are lots of reasons to be bearish. Congress is perpetually gridlocked, the national debt has topped $16 trillion, and the stock market is currently selling at high valuations.
"Plus we've got another five years of choppy stock markets," says Adam Koos, a financial planner based in Dublin, Ohio. "By being defensive, you'll be relatively safe."
But there are other reasons, too. For someone who is 10 years away from retirement, it's OK to be bearish since you'll soon need your money, Koos says. The same is true for investing to pay for college when your child is nearing college age, he says.
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Invest Long Term
Beware of falling into the trap of becoming a short-term speculator, says David Lyon, a principal at Main Street Financial Management LLC in Chicago. The best-laid investment plans are maintained long term, he says. "By focusing on safe avenues, you'll ride out volatility," he says.
Heeding those wise words, here are five investment options for bearish investors, with some riskier than others.
Defensive stocks. This time-honored investment path for bearish investors focuses on buying defensive stocks with consistent dividend yields, low stock market volatility and stable earnings, say Michael Farr, president of Farr, Miller & Washington LLC in Washington, D.C.
Sectors include health care, utilities and consumer staples, which can be good stocks in tough times. For example, consumer staple companies such as Proctor & Gamble and Coca-Cola are good bets, Farr says. Defensive stocks won't go up a lot in boom times, he says. But, when the market drops, they'll fall a lot less than other stocks.
Farr also likes sin stocks, such as alcohol and even tobacco companies such as Altria Group Inc. Shift to higher-earnings growth stocks as you become more bullish, he says.
High-quality corporate bonds. If you're bearish on the stock market, begin shifting some money into investment-grade bonds, says Eric Randolph, director of fixed income at Hopwood Financial Services Inc. in Great Falls, Va. These corporate bonds are rated BBB or higher by bond-rating firms such as Standard & Poor's.
"They're the least risky bonds," he says, since they have low default rates.
When scouting out yields, Randolph recommends comparing investment-grade bonds to brokered certificates of deposit, or those sold through a brokerage or some firm other than a bank. The bonds should bring higher yields. If not, they're not worth your investment, he says. They're also a great diversification tool since bonds and stocks move in opposite directions, he says.
To be sure, you may want to stick with bond funds, Randolph says. Most investors are ill-equipped to trade bonds since they require time and training to research, he says.
Inverse exchange-traded funds. These more exotic ETFs bet against the index they track. So they hope to gain from a drop in the value of a particular index's underlying benchmark. By using derivatives like futures contracts, inverse ETFs are utilized to hedge against slumping markets. So if the Dow Jones industrial average falls 2%, an inverse ETF that shadows the Dow rises by 2%.
However, inverse ETFs are widely seen as highly risky, short-term plays that aren't suited to buy-and-hold investors. "It's very tough to judge short-term trends," Rudolph says. "If you buy them, ask yourself 'how much money can I lose?'"
Contrarian mutual funds. These funds hunt out poorly performing stocks and then sell them when they turn around. "Contrarians go against the grain," says Russ Kinnel, director of mutual fund research at Morningstar. Some of these funds such as the FPA New Income fund and FPA Capital funds are good for bearish investors, he says.
Other funds may use short-selling, where they sell a stock they've borrowed from another investor, Kinnel says. If the stock price falls before they must buy the stock back and return it to its owner, they will make a profit. Those funds tend to be riskier. "Be very selective when choosing a contrarian fund," he says.
Global stocks. Nearly half of the companies in Standard & Poor's 500 index do business outside the U.S., says Rick Ashburn, chief investment officer at Creekside Partners in Lafayette, Calif. The upshot is these companies aren't as dependent on the U.S. economy. So they can churn out stable earnings in good and bad times. Also, global companies have stakes in emerging markets, which are growing faster than the U.S. and other developed markets, Ashburn says.
When buying global stocks, Ashburn prefers ETFs that mirror an index such as the S&P Global 100 or the MSCI Europe Large Cap Index. "To understand even one single stock is a full-time job," he says, so leave it to professionals.
Ultimately, aim to preserve money and still get paid, Ashburn says. That way, if you're wrong, you'll likely not lose money.