Market Survival Guide: Investing in bear or bull markets
The market is a wild place where investments can gain or lose value in big swings affected by everything from economics and politics to emotions and perceptions. Bear and bull are terms for such swings and aptly reflect the savage nature of the market. A bear market refers to a downward trend in prices (as a bear might bat down a rival) while a bull indicates an upward trend (as a bull might toss up a challenger with his horns). Diversification--investing in a wide range of securities--will help your portfolio survive the fight.
When broad market indexes (measurements of groups of stocks that represent the overall market) like the S&P 500 show a drop of 20% or more value over at least two months and investors are pessimistic, a bear has arrived.
Stocks can make money by appreciating in value or by paying dividends, which are portions of the company's earnings paid out to shareholders (not all stocks pay dividends). Since bear markets sound like bad news, your instinct may be to hold off on buying stocks until better times (the average bear market lasts 14 months) or to sell and avoid additional losses. However, you could be missing an opportunity: quality stocks selling at a discount. Bear markets drag down most stocks, even if the company is solid, so seek out bargains and think long-term. There is a greater potential for loss in value until the market picks up, but the risk could pay off in the long term.
Survival Tip: Invest a set portion of money at regular intervals: a strategy called dollar-cost averaging. When prices are down, your money will buy more stocks than when prices are up. This ensures that a certain number of shares are purchased at an average price, thus smoothing out the stock price peaks and valleys.
A bond is a loan, so when you purchase a bond, you are technically lending money to the issuer. The issuer promises to pay back the principal loan at the maturity date plus fixed interest payments throughout the term. This guaranteed return (unless the issuer goes belly-up) makes bonds a safer investment than stocks. For example, in 2008 the S&P 500 lost 36.99%, but long-term government bonds gained 22.67%, according to standardandpoors.com.
Survival Tip: Inflation is the number-one enemy of bonds. Say your bond earns 2%, and the inflation rate is also 2%. Because inflation causes money to lose purchasing power, the real return on the investment is zero. The U.S. government offers a solution: Treasury Inflation Protected Securities (TIPS). To find out more or to purchase TIPS, visit treasurydirect.gov.
Rising prices on securities and investor confidence indicate a bull market.
A bull market is the ideal time to sell stocks and turn a profit. The average bull market lasts more than four years, according to standardandpoors.com. If you're buying stocks during a bull market (and other times for that matter), beware of overvaluation. Check out the stock's price-to-earnings (P/E) ratio, which is simply the market value (i.e. current stock price) divided by the earnings per share. Compare this ratio with historical figures and companies in the same industry. Watch out for companies whose ratio falls significantly out of range.
Survival Tip: Trade wisely. Commission and fees impact earnings, so find a broker with lower fees and commission. Also, you may incur a higher tax liability if you sell a stock less than a year after purchasing it.
Avoid investing heavily in bonds in a bull market. Bonds are a bearish bet because they offer a safer alternative in a time of market mayhem, but when the forecast is bullish, bigger profits can often be made in other investments.
Survival Tip: Despite the fact that bonds don't look so great in a bull market, they still play an important part of an overall investment strategy. Your portfolio should be diverse, and bonds offer a safe place for a portion of your investments regardless of the market. An easy way to invest in bonds is to purchase shares of a bond fund, which diversifies bond holdings.
Sources: investopedia.com; standardandpoors.com; finance.yahoo.com; treasurydirect.gov; schwab.com; marketwatch.com; morningstar.com; investor.gov; money.cnn.com; fool.com; moneywatch.bnet.com