The S&P 500 stock index is flirting with a bear market, but other stock indexes, including the NASDAQ 100, have already entered one. As of Dec. 21, the S&P 500 Index ETF (NYSEMKT: SPY) has fallen 16.4% from its peak closing price on Sept. 20, and the NASDAQ has dropped 23% from its peak close in August. The decline has damaged investors' psyches, and sentiment is reeling in the face of growing uncertainty associated with political instability in Washington.
There's no telling where the market is heading from here. Are you prepared if stocks continue to drop? Here's what you can do right now to protect against a bear market.
How bad is bad?
Bear markets don't happen often, but when they do, it can tempt even the most ardent long-term investor to think short term. The average duration of a bear market (defined as a 20%-plus decline) is 1.4 years. And since 1926, the average decline during a bear market is 41%, according to research conducted by First Trust, an investment manager.
That's undeniably bad, but the declines can be even worse for investors with a penchant for growth stocks. For example, when the S&P 500 declined 38.5% in 2008, the technology-laden NASDAQ 100 declined by nearly 42%. Returns were even worse for the hardest-hit stocks.
Those kinds of drops are nerve-racking if you're not mentally prepared for them. So it can help to put bear markets in perspective. Although they last over one year on average, bull markets last much longer, and the returns generated during those bull markets far exceed the losses associated with bear markets. Since 1926, the typical bull market continued for 9.1 years, producing an average total return of 480%.
When you consider bear markets in the context of long-term returns like that, it becomes much easier to view them as opportunities to profit from, rather than times to fear.
Amp your game
If you're not already contributing money to an investment account like a workplace retirement plan, a bear market is the ideal time to begin. Dollar-cost averaging -- i.e., investing the same amount regularly, such as monthly -- mathematically improves the likelihood of generating returns, because you're acquiring more shares as stock prices fall.
If you already invest on a schedule like this, then bear markets provide an excellent time to boost your contribution rate to make the most of the discounted prices.
Average contributors put about 6% of their income into their 401(k) plan or 403(b) plan, but a very good argument can be made that most people should contribute upward of 10% if they hope to achieve financial security in retirement.
Increasing your contribution rate by a large amount all at once might not be possible, but many employers offer automatic escalators that will increase your contribution rate by a fixed percentage every year until you reach your target.
The additional money that you can accumulate by increasing your contribution rate can be significant. For instance, someone who contributes 6% of a $50,000 income would wind up with an account valued at $414,710.64 after 35 years if the average annual return is 7%. And that person's nest egg swells to $690,078.50 by contributing 10% of that income instead.
A bear market is a sobering reminder that investing in equities is risky, especially if you're older and nearing the retirement finish line.
If the recent stock market decline has taken a bigger toll on your account than you expected, it could be that you're investing too much of your portfolio in high-risk companies, such as small market-capitalization or emerging-market stocks.
Investing some of your money in those riskier areas can provide a nice return during bull markets, but because they can decline more than large-capitalization stocks, exposure to them should be reined in as you get older.
Similarly, if your account has fallen a lot because you've invested on margin, it may be wise to reconsider your investment approach. Taking margin loans from your broker to buy more stock can boost returns when times are good, but since those loans are backed by your investment account, a decline in shares can result in the brokerage calling in your margin loan, forcing you to sell shares at unfavorable prices.
One of the biggest mistakes investors make during a bear market is reacting, rather than proactively planning their investment decisions. Because our natural inclination is to avoid risk, many investors feel pressure to liquidate holdings to prevent their portfolios from falling any further.
Unfortunately, most investors are horrible at timing their selling -- and arguably worse when it comes to deciding when it's OK to buy their investments back. As a result, selling because of a bear market can often mean discarding some stocks that will march on to higher-and-higher highs when the bear market ends.
Instead of indiscriminately selling stocks, a better approach is to create a watchlist of top stocks you'd love to own, but that you haven't yet bought. Preparing a watchlist will make it easier to press the buy button when your favorite companies wind up in the bargain bin, and that could be the smartest move you can make in a bear market.
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