8 Ways to Prepare for a Bear Market

The past 30 years have seen some drastic ups and downs in the market. First, there was the bear market of 2000-2001, then the Subprime Mortgage Meltdown of 2008. The rest of the S&P 500's performance has been interspersed with other, lesser bear markets. The only constant among these bearish periods is that no one saw that they were coming. 

Takeaways

• What is bear market

• Sophisticated strategies to protect your portfolio

• Sensible and efficient strategies to reduce your risk

What is and can you prepare for a bear market?

A bear market is defined by a sustained period of selling leading to the stock market losing up to and above 20% from previous highs. You cannot predict a bear market. Many try but it is impossible to get right every time. But you can be prepared! Here are eight things that you can do to prepare for a bear market.

1. Buy put options on the stock indices

Put options will increase in value when the underlying security that they are based upon decreases in value. So when the indices have a sell off, the value of your puts will rise. Just remember that if there is a market rally, then you can lose your entire investment in short order. But if the markets do drop, then you can make a very tidy profit within a relatively short period of time.

You may want to buy puts at different intervals of time to hedge your bets a little. Then, if the market goes into an extended period of negative performance you can profit more than once. But it would be wise to consult with your stock broker or portfolio manager about this trading strategy.

2. Write covered call options

If you think that the markets will remain flat or decline in value for an extended period, then you can write covered calls on one or more of the stock indices, such as the Dow Jones Index. This way you can generate some extra passive investment income.

Of course, if the index rises in value, then you may get called out and forced to sell your positions at a losing price. But if the index does not go up, then you can count on the income generated by your calls to increase the overall return of your portfolio. Again, you will want to consult with your broker or financial advisor before undertaking this strategy.

3. Sell short to Prepare for a Bear Market

The traditional way to make money in the markets is to buy low and sell high. But it is also possible to sell high and then buy low to close out your position. This is called selling short, and if you have a margin agreement on file with your broker or investment firm, then you can use it to borrow shares of a company and sell them. Then, after the price drops, you can buy them back to realize your profit.

Of course, there is the possibility that after you sell your shares, the price of the index or security that you are trading can go higher, thus resulting in a loss. The safest way to approach this strategy is to sell short against the box, where you already own the shares that you want to sell short. This way, if the price rises after you sell, you can simply deliver the shares to the seller to cover your position.

4. Buy an indexed annuity or IUL

Indexed products have rapidly risen in popularity to become the darling of the life insurance industry. Indexed annuities and indexed universal life insurance are now mainstays for investors who would like to get a portion of the gains in the market without suffering any possible losses. The values of these instruments can only rise and will never fall except when you draw money out of them.

Once interest is credited, it can never be lost due to market action. This way, if the markets continue to rise, then you'll get in on a portion of the gain. But if they fall, then you will stand firm with your principal completely protected. Almost every life insurance company offers several of these products, so be sure to shop around to see who can get you the best deal.

5. Diversify your portfolio to prepare for a bear market

If trading options or selling short is not for you, and you do not want to tie most or all your money up inside an annuity or IUL, then your best bet may just be to spread your money around to as many different types of assets as you can. Do not just invest in the markets in general; divide your stock portfolio into segments that invest in large, mid, and small-cap stocks and bond investing such as government, municipal and corporate bonds.

You may also want to dabble in other asset classes such as real estate, timber, oil and gas partnerships, commodities futures contracts, and hedge funds (if you are wealthy enough to qualify). It can be tempting to load your portfolio up with shares of your employer's stock, but this can leave you very vulnerable to market corrections and equity risk.

Mutual funds and ETFs can substantially broaden your exposure to equities and fixed income securities so that you do not have all your eggs in one basket and still have a margin of safety. A managed futures fund can also reduce the overall volatility of your portfolio below what any combination of stocks, bonds, and cash can do.

6. Shift your money to bonds

If you just do not feel comfortable investing in the market right now, then you could shift your money into a selection of fixed income securities such as Treasury securities, savings bonds, CDs, corporate bonds, and municipal bonds (if you are in one of the highest tax brackets). Although the rate of return that you can earn on your money will be fairly low, it will also not be affected by a market crash and can also generate some current income for you.

One common strategy to guard against interest rate risk is to ladder the maturities of your bonds. This way, you will always have some money coming due, and then you can reinvest that money at current interest rates. Of course, this is only a good idea when rates are rising. If rates are falling, then you may want to invest in longer-term offerings. Or you can reinvest that money back into the markets if they start to rebound.

7. Move your money to cash to prepare for a bear market

If you think that a market crash is imminent, then moving your money to cash may be the best way to capitalize on this opportunity. Selling now can lock in your profits and ensure that you can prepare for a bear market. Then, once you believe that the market has reached its bottom, you can jump in again. Then you can ride out the rebound that almost inevitably comes after every correction. Those who bought in at the bottom of the 2008 market crash reaped huge gains over the next ten years.

8. Invest in precious metals or coins

Metals such as gold, silver, and platinum can be valuable additions to your portfolio, especially during bear markets. The prices of these metals often spike when the markets go down. This is because of their relative safety and ability to hold their own value. These metals are an asset unto themselves, and their values also rise and fall. But there have been many periods of time where they have posted excellent returns. They can be bought as coins, bars, or ingots.  It is also possible to trade futures contracts on these metals instead of buying them outright.

Conclusion

These are some of the most common strategies that you can use to profit from a bear market. Picking which one works for you will depend on your risk tolerance and understanding of what the strategy does. As a rule if the strategy allows you to sleep soundly at night then it is a good fit for you!