Buying Stocks in a Bear Market
A down market is called a "bear market" for good reason. A bear is a powerful, dangerous beast, and many a naive investor has been lured into a bear market by attractive low prices, only to have his finances shredded by the beast. Nevertheless, a bear market offers as many attractive opportunities as a bull market if you follow strict investing rules, are able to tie up your money for long periods and have the courage to patiently avoid panic sells and greedy buys.
Wall Street Warnings
Two important Wall Street maxims are "Don't fight the tape" and "The trend is your friend." What these mean is that you shouldn't use bull market investing tactics when you are in a bear market. When the tape shows lower prices, wait patiently until those prices reach levels that offer true investing opportunities. Making money through near-term stock price appreciation is not a tactic to rely on in a bear market, but slowly accumulating stock in high-value companies over the long term will result in excellent profits -- if you strictly follow the rules of cautious value investing.
Successful value investing is all about reducing investment risk. The three types of investment risk are company, valuation and earnings risk. Warren Buffett, an icon of value investing, looks for companies with historically strong financials through all types of economic situations to lower his company risk. He patiently waits for market lows to buy these good companies at what he considers bargain prices, thereby reducing his valuation risk. Then he carefully monitors his holdings for signs of diminishing earnings due to internal problems that are not temporary. This reduces his earnings risk, because early identification of deterioration at a company helps him liquidate his position before the company's problems become front-page news.
It seems logical that a bear market and selling stock short go together. When you sell short, you are betting on a decline in the stock price -- selling borrowed stock at 50 and hoping to buy it back at 25 in a few days. Another old Wall Street maxim warns of the "bear trap" -- a temporary uptick in the price of a stock that has been heavily shorted. Such a situation kicks off a short-covering rally in the stock that triggers margin calls by brokerage firms asking clients who are short the stock to send in more money to cover the difference between the original sale price (50 in our example) and the new, higher market value (for example, 60). Such a situation can damage your entire portfolio as you are forced to liquidate positions to cover the margin call.
Dollar Cost Averaging
A bear market also offers the opportunity to slowly accumulate high-quality stocks at relatively low prices, over time. Investing a specific amount of money at regularly scheduled intervals results in an average cost per share that is lower than your highest cost paid. It is hard to argue with the logic of this strategy, but it takes careful value stock selection, patience and commitment to continue investing even through bleak times. When the market finally turns around, you will have accumulated a moderate-cost portfolio ready for the price appreciation of a recovering market. This is called dollar cost averaging.
Victoria Duff specializes in entrepreneurial subjects, drawing on her experience as an acclaimed start-up facilitator, venture catalyst and investor relations manager. Since 1995 she has written many articles for e-zines and was a regular columnist for "Digital Coast Reporter" and "Developments Magazine." She holds a Bachelor of Arts in public administration from the University of California at Berkeley.