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5 Rules for Investing in a Bear Market

Written by Jason Stutman
Posted January 23, 2016

The chart below shows the performance of the S&P 500 over the last 12 months.

Things have been pretty dismal, to say the least...

Bear Market 2016After a five-month plateau to kick off 2015, the market took a sharp downward turn back in August. It eventually found support around 1,875 points, attempted to rally, but failed to break through the ceiling later in the year.

Since November, we've seen nothing but lower highs and lower lows. Since the start of 2016, we've witnessed the worst year-to-date performance in stock market history. Scary!

It's safe to say at this point we're either on the cusp of or already caught in the jaws of a bear market. A lot of investors out there are growing concerned, and that's to be expected...

But writing off the market altogether during times of trouble is quite possibly the worst mistake you can make as an investor. There are always vehicles and strategies out there that work — whether stocks are going up, down, or even sideways.

So how, then, should you invest during a bear market? What are the best steps you can take right now to grow and protect your wealth?

Well, everyone's financial situation is different, so the answer will depend on a variety of factors including your age, income, expenses, etc., but there are a few things every person should probably be doing when a full-on crash begins to seem inevitable (even if it isn't).

Bear Market Rule #1: C.R.E.A.M.

You probably don't want to be asking too many rap groups out there for financial advice, but as the great Wu-Tang Clan once said: "Cash rules everything around me (dolla dolla bill y'all)."

Jesting aside, cash truly is king during a bear market. First, because you want to limit your exposure to stocks. Second, because you'll want plenty of capital on hand whenever the market dips.

Which brings us right to rule number two...

Bear Market Rule #2: Stay Bold

It's important to keep your emotions in check and not act too skittish whenever stocks sell off. Fear truly is your greatest enemy in a bear market — just as greed can be your fiercest foe when the bull is raging.

Keep in mind, for one, why you invest in the first place. If you're trying to make a quick buck, chances are you're doing it wrong. If you're looking at the five-, 10-, or 20-year picture, you know good and well that stocks go up over time, and it would be a mistake to try and time it.

A flash sale on the market is just that: a sale. If you were buying in 2015, all you need to ask yourself right now is what has fundamentally changed about the companies in your portfolio? If the only answer you can find is “the stock is down,” then there's no reason not to buy more of that particular stock. After all, you paid top dollar for the same exact thing 12 months ago...

Bear Market Rule #3: Don't be a Midas

I know plenty of you are going to end up disagreeing with me here, but if you fancy yourself a gold bug, my advice is that it's probably time to let go of old habits.

Once a reliable hedge against equities, gold has, to a very large extent, lost its status as the go-to safe haven for investors when stocks start crashing.

As you can see in the chart below, the correlation of gold (in black) and gold miners (in blue) to the S&P just isn't what it used to be. In fact, the correlation between gold and equities has become generally positive over the last year...

Gold Correlations 2015-2016

While conventional wisdom says gold should be rallying as stocks fall, the exact opposite has proven true: Where the S&P has dropped 7% since early 2015, the losses for investors seeking safety in gold have been at least twice as great.

Now, just to be clear, this isn't to say you shouldn't allocate any of your portfolio to gold or gold miners, but if you're relying on them as a hedge against equities, you're not going to wind up too happy. If you really want to hedge, you'll have to follow rule number four.

Bear Market Rule #4: Hedge Like a Pro

The best way to lower your risk in the face of falling stock prices is by hedging your positions directly. I don't just mean buying an ETF that tracks the inverse of the S&P 500, though; I'm talking about using options contracts for their intended purpose.

As intimidating as they might be at first, options are relatively simple investment vehicles that everyone should take advantage of. Simply put, owners of an options contract have purchased the right — but not the obligation — to buy (calls) or sell (puts) shares of a specific stock at a specific price for a set period of time.

You can hedge your stock positions by using options in one of two ways: buying puts or selling calls.

If you buy a put contract, you have purchased the right to sell a set number of shares at a specific price. Say, for instance, you own 100 shares of $APPL purchased at $100.00 apiece. By purchasing a block of 100 put contracts at a $90 strike price, you're capping your losses at 10% per share for the entire duration of the contract (minus the cost of the contracts) because you can sell your existing shares for $90, even if the stock is trading at $50.

If you sell a call contract, you're giving someone else to right to buy a specific number of shares from you at a specific price, but in exchange for immediate income.

Sticking with the prior example, let's say you own 100 shares of Apple purchased at $100.00 each. You can hedge this position by selling a block of 100 call options at a $120 strike price. While this will cap your upside at 20%, in a bear market, those contracts will likely expire worthless anyway. This way, when your stocks fall in price, you can at least get paid in the process.

Bear Market Rule #5: Stop Chart Watching

One of the worst habits you can develop as an investor is checking your trading account and watching stock charts on a daily basis.

While it's certainly important to stay up to date on everything going on with the companies you own, frantically checking your balance will only serve to cloud your judgment.

As much as we all want to log in and see our bottom lines on the rise every day, the reality is that a watched pot never boils, and time tends to move slowest when your eyes are on the clock...

In a bear market, obsessing over your balance is particularly grueling. It's the kind of behavior that drives us to sell when we shouldn't, because after seeing enough red, your brain starts to think the bleeding will never stop.

Sometimes the best thing to do is take a breath, step outside, and enjoy the day. Know that the storm will pass, and when it does, there will be plenty of blue sky ahead.

Until next time,

  JS Sig

Jason Stutman

follow basic @JasonStutman on Twitter

Jason Stutman is Wealth Daily's senior technology analyst and editor of investment advisory newsletters Technology and Opportunity and Topline Trader. His strategy for building winning portfolios is simple: Buy the disruptor, sell the disrupted.

Covering the broad sector of technology and occasionally dabbling in the political sphere, Jason has written hundreds of articles spanning topics from consumer electronics and development stage biotechnology to political forecasting and social commentary.

Outside the office Jason is a lover of science fiction and the outdoors. He writes through the lens of a futurist, free market advocate, and fiscal conservative. Jason currently hails from Baltimore, Maryland, with roots in the great state of New York.

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