Peter Hodson: What you do, or don’t do, during a downturn can have a huge impact on your investment performance
A trader works on the trading floor at the New York Stock Exchange. Photo by REUTERS/Andrew Kelly files In case you haven’t noticed, we are in a bear market. The official definition of such is a market that is down 20 per cent. But I like my definition better: When you catch yourself saying, on a regular basis, “Oh, the market was only down one per cent today, that’s pretty good,” that’s when you are in a bear market.
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What’s an investor to do in a bear market? Often, the best action is to do nothing. Bear markets come and go, but they all end eventually. What you do, or don’t do, during a downturn can have a huge impact on your investment performance. You can’t time the market, so sitting things out is often the right move.
But what about those investors who feel they have to do something? Let’s look at five strategies to help you cope with the growling bear, and offer what we think are some better solutions to what many see as common bear-market strategies.
Go to cash? Many investors worldwide certainly wish they went to cash in November. Hindsight, of course, is 20/20. But the further markets decline, the more we see investors wanting to throw in the towel and go all to cash. They will sit the market out for a while, they say, and come back in when the market settles down. This strategy requires perfect timing. Good luck with that.
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Article content Nope, we think a better strategy is to get rid of your losers. A bear market is a good time to high-grade your portfolio and finally get rid of those stocks you should have sold years ago. If they are held in a taxable account, at least you get a capital loss, which can offset gains elsewhere. Selling a loser can be a guaranteed benefit through tax savings. We all know there are no other guarantees in the stock market, so it can be wise to do some tax-loss harvesting these days.
Buy puts as insurance? Buying put options gives you the right to sell (put) your stock to someone else at a defined price for a defined period of time. It’s like insurance: you pay a premium and get price protection. But puts can be a very expensive form of insurance, and they expire and have to be replaced. Puts have become increasingly expensive these days because of high market volatility.
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Article content We think a better option is selling out-of-the-money covered calls. The premiums are also high, and investors can earn some money while they wait for the market to settle down. The worst-case scenario is you sell your stock at a higher price than it is now, and keep the additional income. That doesn’t sound so bad in a market that seemingly goes down every day.
Load up on one sector? Um, no. Everyone knows the energy sector has been the one bright spot this year. We talk to many investors who want to just move everything into energy. But that is the wrong strategy in a bear market. Oil is strong now, but in a global recession and with the eventual end of Russia’s aggression into Ukraine, oil is not guaranteed to stay high forever.
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Article content Welcome to The Upside Down market, where strange things are the norm Five ways inflation impacts your investments and what you should do about it Five things investors rarely think about before buying a stock but should Loading up on one sector is a bet, not portfolio management. Other sectors are cheap, and we all know how the market likes to reverse and make fools out of investors at exactly the wrong time. For those who don’t believe this, recall that 25 months ago, the barrel of oil that everyone loves today traded at a negative value. A bear market is not the time to make bets — on anything.
Don’t assume the market will keep declining One reason investors sell during a bad market is that they fear the bad times will continue. They look at a stock that is down 50 per cent, and worry it will go down another 50 per cent. Stocks can do this, and mathematically could go down 50 per cent repeatedly and forever. But most won’t.
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Article content Remember: you own a business, and unless your business goes bankrupt, there is usually some value in it at all times. Don’t forget to be positive sometimes. A stock that is down 50 per cent could have a lot of upside potential if the market pivots. The fact that a stock is down 50 per cent in no way guarantees it will keep going down. It could just as easily go up if all the selling is finally over. Think about what markets might do if inflation and interest rates peak, or Vladimir Putin faces reality and realizes his war is futile?
Take a close look at your entire portfolio For those who are truly worried, instead of exiting the market completely, we would use the bear market to take a look at all of your portfolio holdings. In a long recession, financially strong companies will be the best survivors. Do you own any companies that have a lot of debt, or negative cash flow? Could you sit with these companies for five years and never be concerned about them? If not, maybe it is time to high-grade your portfolio.
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Article content Quality is never bad, in a bull market or bear market. Quality companies tend to do better in good times, and less poorly in bad times. There is no shame in selling your riskier companies to focus on better companies. We don’t know how long it will take for the market to recover, and neither do you. Moving up the quality scale in your portfolio will make the bear market — however long it lasts — much less painful. If an investor is not suffering as much, they are far more likely to continue with a long-term investment strategy. And that, if history means anything, will pay off in the end.
Peter Hodson, CFA, is founder and head of Research at 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned.)
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