News Room
3 ways to prepare for the next bear
 
December 22, 2010

By Roger Fillion, Fidelity Interactive Content Services

Worried about the next market swoon? Take these steps to prepare your portfolio for the coming downturn — before it gets here.

If the stock market were a thriller, the action in 2010 would have kept investors on the edge of their seats. And they're likely to stay there next year, with uncertainty over the federal government's budget and 2011 economic growth providing more twists and turns.

The lesson for investors? It’s better to prepare your portfolio now for the next market downturn rather than waiting until stocks have tumbled 20% or more, the traditional definition of a bear market on Wall Street.

“Once the bear market starts, many people start ignoring their statements or go into perpetual procrastination,” says Mitchell Goldberg, founder of ClientFirst Strategy, a Woodbury, N.Y., investment firm. “Before you know it, you’ve procrastinated yourself into a deeper hole.”

Other investors don’t procrastinate at all: They panic and sell once the market is falling, putting them at risk for missing any rebound.

“A knee-jerk reaction to what’s just happened is the worst investment strategy known to man,” says Rich Weiss, head of asset allocation at American Century Investments. Investors who bailed out of stocks near the market bottom in March 2009 missed much of the big rally that followed.

Why prepare for a bear market now?

A look at the market so far in 2010 shows just how volatile stocks remain after the collapse of 2008 and rebound of 2009 (see chart). Remember, too, that bear markets are a fact of life. There have been 15 since 1929, the average lasting 19 months and taking the S&P 500 (.SPX) down a stunning 40%, according to S&P Equity Research.

That means it pays to be prepared, which is both easier and more complicated than it sounds. Good preparation means going back to the basics — crafting a plan to meet your goals; assessing how much risk you can tolerate; diversifying, and, of course, rebalancing. Then you need to add a layer of protection for today’s post-financial meltdown world.

So whether you’re a beginning investor or a grizzled veteran, review these strategies now to make sure your portfolio can ride out a nasty downturn. You’ll have the added benefit of knowing your financial plans are aligned with your long-term goals.

Step 1: Risk you can live with

You may have already thought about your general tolerance for risk, but nothing puts a theoretical assessment to the test like watching your portfolio tumble 30% or 40% in a matter of months. “Risk tolerance is a very personal measure and should vary based on the investor's circumstances,” says Brenda Wenning of Wenning Investments, an investment management firm in Newton, Mass.

Note the word circumstances, Wenning adds. This means not just your appetite for risk (what you think you can live with in a down market) or your emotional tolerance for risk (what you can actually live with), but more importantly your capacity for risk. That’s based on factors such as your age, investment time horizon and overall financial situation.

For example, whether you're 25 or 65, you should have an emergency fund equal to at least six months’ living expenses invested safely in cash. But what about money you want to use for a down payment on a house in several years? Should that be invested in cash or a bit more aggressively, in a short-term bond fund or a blue-chip, dividend-paying stock fund? It depends on your overall time horizon and plan.

The same goes for your retirement savings, though here is where being too risk-averse can hurt. If you invest too conservatively over the long haul, you run the risk of not amassing enough to carry you through retirement. Even if you already have enough to retire on, you need to ensure parts of your portfolio are growing fast enough to keep up with inflation.

An old investing axiom says if you subtract your age from 100 you’ll have a rough idea of what percentage of your portfolio should be in stocks. In general, a 40-year-old investor would keep 60% of his or her portfolio in stocks. “It’s a good starting point,” says Ned Sundermann, president of Sundermann Capital Management, an investment advisory firm outside Denver. “But under certain situations,” he adds, “you may need to rethink those numbers.”

Those situations can be personal. For instance, a 65-year-old woman nearing retirement with little savings is particularly vulnerable to potential losses, but still may need to keep more than 35% of her money in stocks to boost the chances her investments will keep up with inflation.

At times, market circumstances will affect risk assessment. Sundermann, for example, says current prices for intermediate and long-term Treasury bonds – normally viewed as among the safest of investments – are unattractive, since they’re too high. As such, he would advise a 40-year-old allocating now to keep 70% to 80% of his portfolio in stocks (rather than the rule-of-thumb 60%), 10% in fixed-income and most of the rest in cash.

For a more detailed look at what asset allocation makes sense for you, Fidelity's portfolio review tool will give you a target asset mix based on your age and financial goals. Similar tools can be found on Bankrate.com, CNNMoney.com and SmartMoney.com. For additional help contact a financial adviser, who will not only help you devise a plan but also encourage you to stick with it, even when your emotions threaten to throw you off the rails.

“Get together with a financial adviser, come up with a long-term plan, and stick with that plan through the ups and the downs,” says Joanna Bewick, co-manager of the Fidelity Strategic Income Fund.

Step 2: Diversify, diversify, diversify

For decades, most investors used the simplest form of diversification, investing in U.S. stocks, bonds and cash, with some additional assets tied up in their homes.

Diversification can help reduce risk and volatility in a portfolio. Different asset classes perform differently in different situations. And today it’s much easier to diversify than it used to be thanks to technology and the growth of new products. (There’s a mutual fund or an ETF for almost any strategy).

But the reality in today’s markets is that more and more supposedly different asset classes seem to move in tandem, as they did in 2008. That means you’ll need to sharpen your strategy to achieve true diversification. There’s no perfect solution, though.

“No two bear markets are created equal,” says American Century’s Weiss. In 1987, for example, when the Dow crashed in October, international stocks returned 25% that year, as measured by the EAFE International Stock Index, a benchmark of non-U.S. stock markets. International stocks were big losers, though, during the bear markets of 1990 and 2001, tumbling 23% and 21%, respectively.

There are, of course, many paths to diversification. Your stock allocation, for example, should include companies of varying sizes as well as from a wide array of industries. Your bond holdings should include varying maturities as well as issuers, such as governments and corporations as well as possibly tax-free municipal bonds.

But that’s not all. True diversification means including asset classes that are negatively correlated to the U.S. stock market (when U.S stocks zig, they zag), and simply uncorrelated, in other words there’s no relationship to market performance.

"Having assets in your portfolio that don't closely track stocks or move in the opposite direction is important," investment adviser Wenning says. Up to 30% of her clients’ portfolios currently are invested in non-correlated assets like gold, silver, foreign currencies and agricultural commodities. You can buy mutual funds and ETFs that track such asset classes, but proceed with caution. These investments can be extremely volatile.

Wenning says that if stocks reverse course and drop through 1,200 on the S&P 500, she’d reallocate 20% of her clients’ portfolios into “negatively correlated” assets, such as the U.S. dollar. She said one way to invest in the dollar is through the ETF PowerShares DB US Dollar Index Bullish (UUP). Wenning said another alternative would be a so-called inverse ETF, a riskier alternative that’s not for everyone; it’s designed to move in the opposite direction of a particular index such as the S&P 500.

Wenning says a 20% holding in negatively correlated assets would curb the losses for the 40% of the portfolio invested in stocks. “It should cut your downside by half.”

Step 3: Monitor and rebalance

After you build (or adjust) your portfolio, you’ll need to review it at least annually, if not quarterly, to ensure the mix is where you want it.

Selling winners and buying losers is a tough discipline to implement but in the end it is how money is made. If stocks have soared so high that they now make up too much of your portfolio, it’s time to sell; if they’ve fallen to an unacceptably low proportion of your assets, it’s time to buy.

Another way to look at a 20% bear market drop? “There’s a 20% off sale on stocks,” says Scott Wittman, American Century’s chief investment officer for asset allocation. You can take advantage of the “sale” if your target asset allocation isn’t on track.

Lastly, what should you do if a bear market hits and you’re not prepared?

“Take a deep breath and don’t do anything rash,” says David McPherson, a financial planner and principal at Four Ponds Financial Planning in Falmouth, Mass. “I’m not suggesting you should sit still and do nothing. Take stock of what’s happening, and review both how you’re feeling and your current asset allocation.”

Then you can proceed to make the changes you need, gradually. Ideally, though, if you follow the steps outlined here, you’ll be ready before the bear emerges from its cave.

THE BEAR-PROOF PORTFOLIO CHECKLIST

• Inoculate your portfolio against a bear market now, rather than waiting for stocks to tumble 20%
• Do a gut check to determine how much risk you can tolerate
• Next, examine your capacity for risk — how much risk you can actu- ally afford to take — based on your age, investment horizon and financial situation
• Craft a portfolio that meshes with your overall risk profile
• Diversify your portfolio to help meet your goals
• In addition to different asset classes and sectors, don’t forget overseas investments
• Review your portfolio annually, if not quarterly, and rebalance as needed
• Check with a financial adviser if you need help
• Stick to your plan through bull and bear markets