Last week, I shared some bad news…
The next bear market could be one for the ages.
I can’t tell you exactly when it will begin. But I believe it is likely to be more severe — and long-lasting — than any bear market we’ve experienced in decades.
Unfortunately, I fear most investors are utterly unprepared for this possibility. Many folks could lose everything they’ve worked so hard to save.
(If you missed my full explanation, be sure to catch up here before reading further.)
I don’t want that to happen to you.
So, as promised, over the next few weeks, I’m going to share some basic bear market “survival” tools to help you avoid unnecessary losses.
We’ll cover some common-sense precautions you can take right now to reduce your downside risk while still benefiting from any further upside in stocks.
I’ll also share some simple guidelines you can use to protect your hard-earned savings — and even grow them further — whenever the bear market arrives.
Sound good? All right, let’s get started…
Now, regular Money Talks readers know I talk a lot about risk.
In fact, as CEO of TradeSmith, you might say I’m obsessed with risk. I believe risk — or, more specifically, risk management — is what separates the wealthiest, most successful investors from just about everyone else.
So, you probably won’t be surprised to learn that my first recommendation is to make sure you’re managing risk appropriately. And in this case, that starts with managing your expectations.
First, you need to acknowledge that this bull market won’t go on forever.
That should be obvious to most folks. After all, even die-hard bulls generally understand that “trees don’t grow to the sky,” as the old proverb goes. Bear markets inevitably follow bull markets like night follows day.
But human emotions can make it easy to forget this fact sometimes.
That statement probably doesn’t make much sense to folks who have never experienced a complete market cycle. But anyone who had the fortune (or misfortune) of trading tech stocks in the late ’90s, or flipping houses in the mid-2000s, knows what I mean.
In short, when this bull market finally ends and it’s time to sell, there’s a good chance you won’t want to. You’ll come up with all kinds of excuses to ignore your trailing stops or even add to your positions.
Simply being aware of this tendency can help you avoid making unnecessary mistakes.
Similarly, you must accept that you will not be able to sell your stocks at their highs.
It’s tempting to want to try, but it’s nearly impossible to do successfully. It can also create additional risks.
For example, suppose you believe a particular stock is peaking, and you decide to sell it before it hits its trailing stop loss.
What would you do if it then surged to new highs and kept going higher and higher? Would you have the discipline to sit tight? Or would you eventually panic and buy back in, potentially risking all the profits you made earlier?
Of course, hanging on to a stock that has already stopped out is always risky too. You might get lucky and have the chance to sell it higher. But what would you do if it kept on falling instead?
By definition, following a trailing stop loss won’t get you out at the very top of any stock. But it will generally give you the best chance of threading the needle between maximizing your potential gains and minimizing your potential drawdowns.
That’s particularly true of our proprietary TradeSmith smart trailing stops. As I’ve explained before, these are based on an asset’s individual volatility, and they do a fantastic job of identifying when a stock is no longer behaving normally.
OK, now that you’ve prepared your mind for the possibility of a bear market, the next step is to prepare your actual portfolio.
This begins with making sure you’re following the three fundamental TradeSmith risk-management principles I’ve shared with Money Talks readers previously.
First and most important, you absolutely must have a predetermined exit strategy for every investment you own.
Again, here at TradeSmith, we prefer trailing stop losses. And I believe our smart trailing stops are hands down the best stops you’ll find anywhere. But if you’re not a TradeSmith subscriber, even using a simple 25% or 30% fixed-percentage trailing stop is better than nothing.
(If you’re new to trailing stops, you can read a full explanation of them here and here.)
Second, you must be sure to size your investments appropriately.
The reality is, even our powerful trailing stop losses can’t necessarily protect you from a huge loss if you bet too much of your portfolio on any one investment.
Unfortunately, most folks only think about position sizing in terms of how much money they’ve invested — or how many shares they own — if they think of it at all. And this can get them into all sorts of trouble.
A better way to think about position sizing is in terms of risk parity. In practice, this just means investing more money in lower-risk positions and less money in higher-risk positions.
(If you missed it, I covered proper position sizing in more detail here.)
Finally, you also want to be sure you’re holding a reasonably diversified portfolio.
Diversified can mean different things for different investors, depending on age, risk tolerance, net worth, etc.
The idea is that it’s usually not a great idea to place all eggs in one basket. You want to be sure you’ve spread your investment risk across at least a few different asset classes if possible.
(You can learn more about diversification and asset allocation here.)
Now, we’ve covered each of these ideas before, so I hope most Money Talks readers already have this basic risk-management plan in place.
But if you don’t, I urge you to take a few moments this weekend to do so. It’s just that important, and it’s the foundation of everything else I’m going to share in this series.
Once you’ve done that, the last step is to assess the overall risk of your portfolio.
You see, you could follow each of the principles I just mentioned and still be risking more than you’re comfortable losing.
The easiest way to check this is to calculate your expected losses if each position you owned were to hit its trailing stop-loss simultaneously.
Now, part of the reason for owning a diversified portfolio of different assets is to reduce the probability of this kind of worst-case scenario occurring.
In most cases — outside of the most severe bear market declines — it’s rare for different asset classes to fall in unison.
But this exercise can still be helpful. And depending on the mix of assets you own — and the individual risk of each position — the results can be surprising.
Some folks might find they’re risking 10% of their overall portfolio, while others might find they’re risking 30%, 40%, or more.
Ultimately, the actual result is less important than whether it’s suitable for your circumstances and risk tolerance.
(TradeSmith subscribers can also use our Portfolio Volatility Quotient or PVQ Analyzer tool — which accounts for these typical “correlations” between different assets — for a more conservative estimate of overall portfolio risk.)
If you do find that you’re potentially risking too much, you’ll likely find it’s due to one of two common issues related to asset allocation:
- You’ve allocated to a good mix of assets, but you’re still holding too much of your portfolio in more volatile assets (like stocks) and too little in less volatile assets (like fixed income or cash).
- Your overall asset allocations are acceptable, but you’re taking too much risk in one or more of those assets. For example, you may hold only 50% of your overall portfolio in stocks. But if most of those are speculative growth stocks rather than stable blue chips, you could still be taking too much risk in stocks.
In any case, your options include shifting your overall asset mix between more and less volatile assets, replacing riskier positions with less-risky alternatives in the same asset class, or a combination of both.
There isn’t a right or wrong way to do this. Your goal is simply to bring your overall portfolio risk down to a level you can tolerate in a worst-case scenario.
This strategy will help you sleep more soundly when a bear market eventually arrives. But it can also give you the confidence to remain invested in the current bull market as long as possible.
Next week, we’ll talk about the importance of cash in a bear market, including how and when to “raise” it… how much to hold… and how to hedge it against inflation and other market risks.
In the meantime, keep your bear market questions and comments coming at [email protected]. As always, I can’t personally respond to every email, but I read them all.