One of the commonly held beliefs among casual investors is that you make money in a bull market as stocks rise and lose money in a bear market, when stocks fall.
While it is true that the value of your investments tend to increase or decrease depending on the market’s trajectory, it does not mean that you cannot profit from a bear market at all.
In fact, a bear market presents excellent investment opportunities for the discerning investor. If you make the right investment choices, you can profit enormously when the market rebounds.
Here are seven strategies that can help you profit from a bear market.
Max out your 401(k) and Roth IRA
One of the best ways to build a highly profitable investment portfolio is to buy index funds consistently through your 401(k) and Roth IRA. The stocks you buy when the market is down will increase in value when the market climbs back up.
Maxing out your 401(k) contributions, in particular, can be a very profitable strategy in the long run, especially if your employer matches a portion of or all of your contributions. You can use the money in your account to invest in a wide variety of stocks through index funds and reap the rewards when the market recovers.
Invest in dividend-paying stocks
Dividend paying stocks are considered an excellent investment choice for a number of reasons, one of which is the fact that they provide you with a steady stream of income even when the market is down.
This is because the stock value of a company is determined to a large extent by the buying and selling trends in the market. Dividends, on the other hand, are paid out of the profits made by the company.
This is why large companies with strong fundamentals tend to perform well irrespective of market conditions and manage to pay dividends to their shareholders on a consistent basis. So, even if their stock value goes down in the event of a downturn, you are still assured of an income.
When the market recovers, the stock value tends to increase, as a result of which the overall value of your portfolio also increases considerably.
Invest in reliable, profitable companies
A downturn or a recession presents you with an excellent opportunity to invest in highly-profitable companies whose stock value has gone down due to the selling spree in the market.
Many casual investors tend to panic at the very first sign of a recession and dump the stocks they own. It usually leads to a selling frenzy, as a result of which the stock value of many companies — even companies which are financially stable and have excellent growth potential — tends to decline. You can scoop up these stocks for pennies on the dollar and reap the rewards when the market recovers.
Now, the question is, how do you find good stocks to buy in a bear market?
There are many factors you can look for: healthy sales figures, a good debt-to-assets ratio, a robust growth outlook, a good bond rating (A, AA, or AAA), and good financial ratings (A rating or above by independent agencies).
Invest in stocks that perform in a recession
One of the most important things you need to know about bull and bear markets is that they do not have the same kind of impact on all sectors. Some sectors tend to perform excellently during a bull market.
The most common examples include technology, automobile, machinery, and home improvement.
Some sectors, on the other hand, perform well during a bear market. The most common examples include food and beverage, utilities, pharmaceuticals (generic drugs in particular), and other such sectors which cater to basic human needs.
Your equity investments are likely to lose their value in a downturn or a recession. To offset your short-term losses, you can invest in bonds and bond funds, which are a much safer investment choice compared to equities and offer you guaranteed returns.
You can buy Treasury bonds, municipal bonds, and AA- and AAA-rated corporate bonds. You can also invest in exchange-traded funds which invest in the aforementioned bonds and other fixed-income investments.
Buy stocks on margin
You can get a margin loan from your brokerage firm to invest in stocks that have depreciated in value due to the downturn. When the market bounces back, you can sell the stocks for a profit, repay the loan, and keep the difference. The strategy is commonly used by seasoned investors to profit from a bear market.
You should be extremely careful while buying stocks on margin due to the risks involved. If, for example, the stocks you buy do not increase in value even after the market recovers, you might have to sell them at a loss and repay the loan with your own money.
So, you should only buy stocks whose value has notably declined and are highly likely to appreciate in value when the market recovers.
This is yet another high-risk, high-reward investing strategy which can help you profit from a bear market. If you have a knack for picking overvalued stocks that are likely to lose value in the event of a downturn, you can employ this strategy and reap the benefits.
For instance, let us assume that a particular company’s stock — let us call it XYZ — is overvalued and is likely to depreciate in value in the very near future. You can borrow 100 shares of XYZ from your brokerage firm and sell them right away for $50 per share. You now have $5,000 ($50 x 100) in cash.
Shortly after, the stock value of XYZ plummets to $35 per share. You can now buy 100 shares of XYZ (which is what you owe the brokerage firm) for $3,500 ($35 x 100).
You can then return the shares to the brokerage firm and pocket the difference, which in this case is $1,500 ($5,000 – $3,500).
Remember, if the stock value remains unchanged, you will not earn any profit from the aforementioned transaction. If it actually goes up, you will have to buy back the stocks you sold at a higher price and return them to your brokerage firm, suffering losses in the process. Be extremely cautious while short-selling stocks.
The bottom line
The strategies listed above can help you make the right investment decisions in a downturn or a recession and increase your short-term and long-term returns.
Remember, however, never, ever try to “time” the market.
Instead, keep investing at regular intervals and think of stock market crashes as an opportunity to invest in assets that can pay you rich dividends in the long term.