How to Invest in a Bear Market

Takeaways

• The benefits of Pound-cost averaging

• Option strategies to use in bear markets

• Why dividends become important

How to invest in a bear market: Pound-cost averaging

This simple strategy simply requires you to continually buy shares on a periodic basis over a predetermined period. When the share price goes up, then you will buy fewer shares. Then you will buy more shares when the price goes down. This strategy is most effective with traditional open-ended mutual funds that will allow you to buy fractional shares.

When markets sell off, this can be an opportunity to pick up some investments at a discount. Pound-cost averaging into a mutual fund will lower the overall cost of the shares being purchased over time. This is a good strategy to use for funding a SIPP or employer-sponsored retirement plan. You may find a good stock or fund to invest in that has sound fundamentals but is trading at a discount. This could be a good time to start buying in.

How to invest in a bear market: Income investing

If the markets are down and you are not inclined to find anything trading at a discount, then you could pick up some income-producing instruments that can improve your cash flow for the time being. Of course, guaranteed instruments such as U.S. Savings Bonds, Treasury securities, and CDs are all paying abysmal rates of interest right now. You may want to consider taking a bit more risk and looking to other, more aggressive fixed-income offerings. The possibilities could include:

• Junk bonds or junk bond mutual funds - These funds invest in bonds that are rated below BBB. Because the risk of default is higher with these bonds, they pay higher rates of interest A junk bond mutual fund can provide you with greater diversification along with professional management.
• Preferred stocks - This type of stock still represents a share of ownership in a company. However, they typically have no voting rights. Preferred stocks pay dividends on a monthly or quarterly basis. Their dividend yields are usually about one or two percent higher than guaranteed offerings.
• REITs - Real estate investment trusts often pay competitive rates of interest and can also provide capital growth over time. They offer monthly or quarterly income by investing in a pool of commercial or rental properties.
• Limited partnerships - They can sometimes be riskier than stocks, but there are many limited partnerships that offer competitive yields. Just be aware that with some partnerships, your cost basis is reduced by each interest payment that you receive. So when the time comes to sell it, you may have a sizeable capital gain to report. For this reason, limited partnerships are good vehicles to own in a traditional or Roth IRA.

How to invest in a bear market: Option strategies

Buy Puts

This is the most aggressive way to profit during a bear market. When you buy a put option on a stock, index, or ETF, then you pay a premium to have the right, but not the obligation, to put the stock to the buyer at a specific price, known as the strike price.

The further away (downward) that the holding trades from the strike price, the more valuable the put option becomes. For example, if you buy 10 puts on a stock trading at $50 with a $49 strike price, then those put options will be worth considerably more than you paid for them if the stock price drops to $38 a share before the expiration date. You can either exercise the put and deliver the actual shares or you can simply close out your position at a profit.

Of course, if the stock or fund price moves upwards, then you risk losing all the money you spent buying your puts. Of course, you may be able to sell them back at a loss to minimize your losses. But the most money that you can lose with this strategy is the amount that you paid for the puts.

Sell calls

You can also profit from a bear market by selling call options on various types of investments such as stocks, indices, or ETFs. When you sell a call option, you will be paid a premium that you get to keep as long as the underlying security does not trade above the strike price.

If that happens, then you will have to sell the underlying shares at the strike price, which will be lower than the current market price. Your risk is less if you already own the shares that you are writing the calls against; this is known as "covered" call writing. This is a common strategy used by many experienced investors to generate additional income when the chips are down. Covered call writing is the most conservative form of options trading used today.

Sell short

If options are not your thing, but you think that the price of a stock, ETF, or index is about to drop, then consider selling short. With this strategy, you will borrow the shares and then sell them now while the price is still high. Then you will buy them back to close out your position after the price drops. You will need to have a margin agreement with your broker to do this. You can also sell shares short that you already own.

For example, say you own 1000 shares of ABC Company, and the stock is $75 a share. You believe that the price will drop to $50 a share in the near future. You can borrow 1000 shares of ABC Company from your broker and sell them now at $75 per share. Then you can buy back those shares after they drop in price.

This is known as shorting "against the box" because you already own the shares you were borrowing. This lowers your risk, because if the price of the stock rises instead of falling, then you would take a loss. You would have to buy back the stock at a higher price than what you sold it for. This is the risk you take with selling short. This is a higher risk strategy.

Flight to safety

If you are not sure what the markets are going to do next (and, of course, no one ever really knows what it will do), then you could simply move some or all your depressed holdings into cash or cash equivalents for a while. This could be a useful margin of safety.

If you sell some of your holdings at a loss, then you may be able to deduct those losses against any gains that you have realized during the year. Or you may be able to deduct a portion of those losses against other types of income that you received, depending on various factors.

Conclusion

These are just some of the strategies that you can use to profit from a bear market. Whatever the market, disciplined investing is always best. By using discipline you ensure you can take advantage of the opportunities that a bear market will give you. You are also in a position to avoid the worst. Remember a bear market is not the end of the world, it will eventually turn into a bull market, so do not lose your head in the meantime!