What to Do in a Bear Market?

Preparing for a bear market is clearly a vexing problem, given the fact that bear markets are usually quite different. Here is what many experts think:

Don't try to time the market by switching to cash

Anyone who tries to trick the bear by selling investments and piling up cash will likely suffer less-than-perfect timing and miss out on big stock market gains. Unless you know something the experts don't or are extremely lucky, you probably won't get rich playing the timing game.

Recognize the limitations of bonds and gold

Given that high-quality bonds and bond funds have evaded the bear in a number of situations, they're a good way to ensure that at least something in your portfolio will perform reasonably well during periods of extreme stock market weakness. There are some caveats, though. For one, tucking too much money in these bear market champs is a good way to avoid bull markets for stocks, too. During the bull market of the 1990s, bonds didn't return nearly as much as diversified domestic-equity funds did.

Moreover, these funds aren't completely bulletproof. For starters, being better than everyone else isn't the same as being good. Bonds may have been the best thing going in 1990, but they still lost money as the Persian Gulf crisis unfolded and interest rates spiked. Also, keep in mind that these funds do endure their own separate bear markets from time to time. Investors learned that the hard way in 1994, when long-term Treasury bond funds plunged 7%, and again in 1999 and 2009, when long-term Treasuries lost 9% and 12%, respectively.

Be wary of committing to bear-market funds

Some funds are explicitly designed to gain money when other assets are losing—so-called bear market funds. These funds typically bet against an asset class or market sector by shorting that same sector, and many bear funds galloped to robust gains in the recent bear market. However, remember that bull markets won't likely be kind to these funds. It's also worth noting that stocks have increased in value over long periods of time, and bear markets tend to be relatively brief in historical terms. Using a bear market fund effectively requires that you successfully predict when the market is going to head south, and few, if any investors, have shown any ability to do this consistently.

Grin and bear it

Let's face it: investing has its risks, one of which is losing money. It's going to happen from time to time. Diversifying across a variety of fund types and asset classes won't prevent the blow, but it will soften it. Every bear leaves at least a few fund categories with relatively minor injuries.

After setting up a diversified portfolio that meshes with your long-term goals, the best plan for many of us will be the most obvious one: stay the course, invest regularly, and promise yourself not to panic when (not if) the market stumbles. The prospect may seem unappealing, but the alternatives could be worse.