How to Prepare for a Bear Market

A decade after the financial crisis, stocks continue to push new all-time highs. While there are always worries that could keep investors on the sidelines, this year's Wall Street advance has been especially volatile as many pundits cite reasons the end could be nigh for this bull run.

While investors are best served ignoring such noise (as Warren Buffett continues to preach even now), an important part of investing is being prepared for multiple outcomes. If a possible bear market is on your mind, here's how to start preparing for a downturn without going completely to the sidelines.

Diversify those profits

Not being prepared for multiple outcomes is one of the biggest risks right now. That's because many investor portfolios are over-concentrated in just a few stocks. Technology has been one of the best sectors over the last 10 years, and after a decade of incredible returns, just a few of these companies make up a very large percentage of the S&P 500.

That's the result of huge out-performance over the S&P 500 index, which, as of this writing, has returned "only" 297% since March 1, 2009. There are lots of stocks that have posted similar performances in the last decade, and many investors now have high percentages of their portfolios concentrated in a handful of names -- in essence betting on just a few outcomes instead of diversifying for many. If big tech has a slowdown, like what Facebook investors experienced earlier this year, many investors may find out they were out of balance too late to protect themselves.

Now is a good time to review those positions and make sure your portfolio isn't overly relying on the performance of just a few. Consider taking some of those profits off the table in order to diversify.

Buy stuff that's on sale

When looking for new stocks that might weather a bear market, start with companies that have under-performed the market even though they still have solid businesses. Re-allocating to forgotten or down-and-out companies instead of cyclical or momentum plays (like the aforementioned technology stocks, restaurants, and other non-essential consumer goods and services) is a great way to play defense without getting out of the market entirely.

That's because in a recession-fueled bear market, consumers tend to cut spending and focus on value and essential needs instead. As a result, high-flying stocks can turn into the biggest losers, and discretionary goods and services companies can lose customer traffic when households tighten up on spending.

High dividend-paying companies that have plenty of free cash flow are a good corner of the market to explore. Here's a list of companies that have lagged behind the overall market in recent years and now tout low price-to-free-cash-flow ratios and high dividend yields.

If you need more help, Fool contributors regularly make value picks from high-quality but long-forgotten corners of the stock market, like these articles on high-yield dividend payers and deep-value growth plays.

Cash is king

Warren Buffett has helped make the "fearful when others are greedy and greedy when others are fearful" contrarian view of the market famous. In order to act on that advice and take advantage of a market downturn, though, you'll need cash.

Some might argue that holding cash and waiting for a more favorable time to invest sounds like market timing, but consider that Buffet is following his own advice. At the end of the second quarter of 2018, Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B) had over $111 billion in cash on the books. That doesn't mean the company has stopped buying stock altogether -- Buffett added to his position in Apple again -- but being patient and waiting for a good value is prudent after a decade-long bull run.

If you're near the beginning of your investing journey, what you save every month might be good enough to accomplish this goal. If your rate of savings is a high percentage of your account value, then dollar-cost averaging -- purchasing a set dollar amount of a stock at regular intervals -- into your current positions should get the job done. If you're further along on the journey and you have years of savings, hold some of those profits back to deploy when a quality stock goes on sale. If you're unsure how much cash to keep, here's a point of reference: Berkshire had about 15% of its assets in cash at the end of the second quarter.

Getting prepared for a possible bear market isn't timing; it's all about being prepared for multiple possible outcomes -- the real definition of staying "diversified." After years of technology out-performance and markets hovering around near-record levels, now is a good time to assess your portfolio's readiness for a change in direction.

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