Bear markets are an inevitable fact of life for investors. However, they don't have to be feared and in fact, there are ways to take advantage of a bear market to your benefit.
It's helpful to know what causes a bear market and how you can use it to enrich your retirement accounts and investment portfolio.
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What Is a Bear Market?
Typically, investors watch the major market indices, such as the S&P 500, which contains 500 of America's largest companies, the Dow Jones Industrial Average, which is made up of 30 of the largest industrial companies, and the NASDAQ composite, to gauge the trend of the market. Markets are constantly going up and down; they're either bullish or bearish.
A bear market is generally considered a continuous decline in stock prices of 20 percent or more from a recent high, but it's only a benchmark, not an exact science. For example, if the S&P 500 is at 4,500, bear market territory would be a decline of 900 points (4,500 x 20 percent) to 3,600. A 10 percent sell-off is considered a market correction and usually only lasts a few months.
In a bear market, investors are pessimistic and have no confidence in the future. They ignore good news and push prices lower by continuously selling. This state of mind continues until prices become so low that investors believe they are bargains and start buying.
How Often Do Bear Markets Occur?
Bear markets are unavoidable and have occurred 12 times since 1932, according to research from TheStreet. Over this period of time, they have lasted an average of 25 months. The longest bear market occurred in 2000-2002 and lasted 671 days, while the shortest was in 2020 and only lasted 23 days.
By comparison, there have been 14 bull markets in the same time period with an average length of 59 months with the longest one lasting 113 months in the 90s.
What Causes a Bear Market?
Bear markets usually precede any economic downturn since they indicate that investors believe that conditions are going to get worse, and they start to sell their investments and get into cash for safety. Investors believe that an economic recession will reduce corporate profits, so they sell their stocks, which pushes prices even lower.
Bear markets are usually caused by higher rates of inflation, political uncertainty or overheated economies driven by high levels of consumer spending. The anticipation that the Federal Reserve Bank, also known as the Fed, is going to raise interest rates to reduce inflation and slow down the economy is enough to create a stock market downturn.
In a certain way, investors' pessimism becomes a self-fulfilling prophecy that creates a bear market.
Investment Strategy for a Bear Market
Watching the value of your retirement and investment accounts take a sharp decline is painful, but the good news is that prices will recover. It could take only a few months or even a couple of years, but they will recover. So, the best strategy, unless you desperately need the funds for an emergency, is not to sell anything and wait for the recovery when the market regains investor confidence.
However, knowing when the next bull market will begin is a difficult task. Historically, the largest percentage recovery occurs during the early stages of a market recovery, but you won't know for sure when that will be.
Bear markets are inevitable, but they can be used to diversify and improve your portfolio by buying stocks at bargain prices.
If you have enough cash, you might want to consider that a bear market presents attractive opportunities to buy stocks at bargain prices and improve the diversification of your portfolio. You should continue to add to your retirement accounts during bear markets. You'll be buying at lower prices and lowering your average purchase prices.
Since history has shown that bear markets eventually recover, you can shift your views from pessimistic to optimistic by taking advantage of lower prices for higher potential gains in the future. This might also be a good time to assess your risk tolerance and consult your financial advisor about adding different types of investments, such as mutual funds and exchange-traded funds (ETFs), to your portfolio. Keep your focus on the long term.