In this post we get into the detailing of investment options in bear market and their relative pros and cons across available investment options. The objective of this post is simple. To keep your capital safe and work hard even in adverse market situations. Yes, it is absolutely possible.
Bear market investment options: the asset classes
Always remember that there are a number of places you can invest your money – you don’t have to be fully invested in stocks at all times, and you may consider adapting your portfolio to changing circumstances. Your main choices of asset class are:
Shares in big companies, especially the large cap stocks
Shares in small companies
Bonds, especially government bonds
Physical assets such as gold or property
Cash accounts | Liquid funds
Each of these investment categories has different risk and return characteristics and the normal rules apply: the lower the risk, the lower the potential return; the higher the risk, the higher the potential return.
But the assets also behave in different ways in different economic conditions. In a bear market some will have a tendency to fall, but fall less than the market. Others may hold their value, or increase as shares fall.
We’ll look at these characteristics of different investment options and figure out the best given the market scenario. At this stage, the point to grasp is that when markets undergo a change of sentiment – from bull to bear, or vice versa – you must take a long hard look at where your money is invested, and make sure that the assets you own give you a balance of risk and return that you are comfortable with.
Generally speaking, the risk/return profile of the assets above is as follows:
Shares in big companies – moderate risk and return (if carefully selected)
Small company shares – higher risk and return (even if carefully picked)
Government bonds – moderate-low return and limited risk
Physical assets – stores of value but no income return
Cash accounts and liquid funds- low return and no risk (other than erosion by inflation)
Investors differ in the degree to which they are prepared to tolerate risk. Before deciding how to plan your bear market investing, it’s important to be realistic about the time horizons you have, and to reconcile the returns you want to make up with the risk level you are prepared to accept.
Stocks: blue chips vs small caps
Many investors may prefer to stick with stock investing in a bear market even though they are well aware the general trend in prices is downward. This is a perfectly viable option.
Selected shares can appreciate, sometimes substantially, in the course of a bear market either because they started out being modestly valued, because they operate in an industry that survives poor economic conditions intact, or because they have something unique to offer.
In general, however, past experience has shown that conservatively managed blue chip stocks may perform better during a bear market, at least in relative terms, than smaller companies.
Initially blue chips may bear the brunt of the sharp initial sell-off, because their shares are more easily traded. Later, the relative lack of liquidity in smaller company shares becomes a drawback, not least because institutional investors steer clear of shares with poor liquidity. Other reasons for being wary of smaller companies in a bear market are:
They are more likely to be dependent on a single industry
They are more likely to be dependent on the demand scenario
They are more vulnerable to having bank credit reduced or removed
They are less able to raise new capital in the markets on reasonable terms
As bear markets end, the reverse is likely to be true. Big stocks will react first, because they represent an easy way for big investors to channel money into the market. Smaller capitalization stocks come more into their own as the new bull market progresses. They then do the catching up.
Investors nervous about the prospects for stocks in a bear market may well find it pays to take refuge in bonds. Not only will you have the comforts of relative certainty and safety but you also have the prospect of tax-free capital gains if the value of the bonds rises (or losses if it falls).
First – a reminder of what bonds are:
A predefined fixed rate of interest
Repayment of capital at a future specified date (the maturity date)
The rate of interest you get depends on the risk rating of the issuer. Government bonds of the major Western economies (‘gilts’ in the UK), are considered the safest, then corporate bonds issued by blue chips, and at the bottom come ‘junk’ or high-yield corporate bonds, and government bonds of less financially-stable countries.
Compared with shares, bonds have some advantages and some disadvantages. On the plus side, your income is certain, your money is generally safe, and liquidity is good. On the minus side, the rate of interest you get may fail to keep pace with inflation, the upside potential is not as good as stocks, and historically bonds have not performed as well as stocks over the long term.
In a bear market, the virtues of certainty and safety may outstrip the disadvantages, but, as with shares, the price you pay is important. If you plan to hold your bonds to maturity, there is no problem: you will get your capital back. But if you plan to sell them before maturity, the price you get will be what the market is willing to pay at the time. And bonds can be just as volatile as stocks. In general:
Bond prices rise when interest rates go down, and fall when they go up
Bond prices rise when inflation goes down, and fall when inflation goes up
Since, in bear markets one expects falling interest rates, one also expects rising bond prices. But choose your bonds with care. Like stocks, risk and reward go hand in hand.
Cautious investors may consider sticking to government bonds with a repayment date between two and five years out. These have a low risk of default, fairly low price volatility and can be bought easily through brokers.
Corporate bonds, even if held in collective investments such as unit trusts, are much riskier than government bonds, especially in difficult economic times, because there are increased risks that the issuing companies may default.
Thinks hard about whether you intend to hold the bond to maturity. If you don’t, be aware that you face a potential capital loss if you sell it early.
Consider your tax position. As capital gains on gilts are tax-free, these are better for higher rate taxpayers.
Remember that bonds experience their own bear markets: with every point rise in inflation and interest rates, bonds lose their value.
Bull markets in bonds usually end some time before bear markets in shares have run their course
Property and gold
Bonds and shares are tradable securities, but investors can also invest in physical assets – in particular, gold and property.
The reason for investing in physical assets as opposed to securities like bonds and shares is that they are presumed to hold their value better.
Taking property first, one of the attractions of holding property is that the falling interest rates that usually accompany a bear market make borrowing to buy a property cheaper and boost property prices. Property can generate significant income from lettings, but their major drawback is that, unlike shares and bonds, they are hard to sell quickly.
Gold is prized for its scarcity and indestructible properties, and for its high value relative to its bulk. Pundits have dismissed the attractions of gold as an investment and its price has languished quite a bit for Indian market.
One alternative to these classic stores of value is to buy shares in companies that are exposed to their price movements. Think about Titan, it goes up with gold price rise. This is not the straightforward option is sometimes seems. Remember the following:
Property shares tend to perform well in the early stages of a bear market, and many of them can often be bought at a discount to their underlying assets.
It is highly recommended not to invest in housing properties with home loans, contrary to popular beliefs it is a deserter of an investment and makes only the bank and the builder rich. Will deal with this in a separate post.
Gold mining shares are more difficult to assess. Investors need to beware of possible political risk and also the fact that some mines may be uneconomic with the metal at its current price.
In a prolonged bear market, broad based mining companies should be avoided until some form of economic recovery becomes evident, since recession and depression may limit the demand for the materials they produce.
Natural resources are also typically priced in US dollars, so any weakness in the dollar will have an adverse impact on profits reported to Indian investors.
Cash and cash equivalent
It is widely said that in a bear market ‘cash is king’.
One advantage that private investors have over big institutions is that they do not have to be fully invested in the market. They can keep their money in cash if they want. Institutional funds can keep some of their money in cash, but not for long – they have to be out there looking for returns, which means being invested in the markets.
Also – big investors find it hard to move in and out of the market without prices moving against them. Private investors do not usually have this problem.
The problem with keeping a high level of cash balances, however, is that interest rates generally fall in a bear market. This reduces the return produced by cash holdings and increases the pressure on investors to find an alternative home for the money.
How much cash you wish to keep in reserve may depend on your appetite for risk (or lack of it). In tough economic times it is always worthwhile giving priority to reducing outstanding debts, and stepping up the amount you have put on one side for contingencies such as redundancy or unemployment.
Let’s assume, however, that you have sufficient cash to cover these eventualities and an amount left over you are prepared to commit to the market.
There are several basic rules that may be considered:
Don’t be afraid to maintain a substantial part of your investments in cash if the market mood darkens. It gives you time to think and great entries into undervalued stocks.
Make sure the cash you have on the sidelines is earning the maximum rate of interest possible.The best option is to put it to no load liquid funds.
Remember that bear market rallies can be sharp. Participate in them if you wish, but be prepared to switch quickly back into cash as they falter. One can think of making a few smart trades if they are proficient enough.
Avoid companies that have given below expected results. They will hardly run in the relief rallies. The last result becomes important in a bear market.
If in doubt – stay out.
So, from the above discussion one can prudently do a mix and match activity to make their money work even in adverse market condition. One thing that an average investor needs to be cautious about is his own risk profile. In bear market adventures are not recommended as they mostly end up with accidents.
Being a avid lover of stocks, in the next part (part 3) of bear market investing post i’ll try to get deeper into stocks and figure out different ways of earning reasonable returns from stock market even in a bad bear attack and will come with few thumb rules that gives bear proofing cover to ones investment.