How should you invest during a bear market?

Newspapers around the world are currently full of talk about bear markets. Investors are confused and continue to ask us what they should be doing in these times. In our view, a downturn in the markets is not unusual, and in fact presents a great opportunity for investors.

In a down stock market, many people are inclined to give the picnic basket to the bears. In investment terms, it means they rush out of their sound intellectual framework to the shelter and perceived safety of bonds, GICs or cash.

Smart asset allocation

We recommend a better way to get through these sluggish markets: a well-designed policy of asset allocation pointed at the long term.

Asset allocation requires a long-term presence in a mix of asset classes, geographic regions, investment styles, and capitalization ranges, including growth stocks, value stocks, bonds, and cash, along with frequent portfolio rebalancing. Asset allocation does not employ market timing, which might be considered a diametrically opposite approach for many investors.

You can't time the market

Market timers are trying to predict market highs and lows and get on the sunny side of the swings-a nearly impossible task. As advisors, we are constantly bombarded with market timing advice from pundits, but if these gurus truly knew how to time the market, would they be sharing their insights? While many people may agree with the idea of market timing, it is difficult to pull it off with any consistency. We find that bear markets have demonstrated the ability to quickly transform otherwise rational asset allocators into fidgety market timers.

Many investors believe that in bad times something must be broken and some tinkering is necessary. Investors who originally set their investment horizons at 10 years or longer begin to analyze their portfolios on a monthly or even weekly basis, which can be a mistake. This tinkering can sometimes get you in trouble because in the short term, performance is exaggerated. Economic expansions cause expectations to soar too high; in recessions, the sky is falling.

As the author of the Intelligent Investor, Benjamin Graham tells us:

"In the short run, the market is a voting machine, but in the long run it is a weighing machine."

Common investor errors in a bear market

Trying to time market swings is a classic investor mistake during bear markets. However, another big mistake is refusing to make portfolio changes. Certainly, you don't want to make a change just because something is out of favour, but you do want to make sure that you have quality investment managers who are the best in their mandate.

In a time of excess gains or a "bubble" environment, not all investment managers will match the market's exuberance. Some, due to their investment philosophy of not overpaying for sound investments, may also lag the market. In recessions, on the other hand, some otherwise solid managers may be forced into lower short-term performance because their sound investment stocks are also affected by the market, investors' perceptions, unexpected bankruptcies, etc. In bear markets, it is vital to shed shaky investments and reinvest your dollars for the long term into sound portfolios.

A third classic investor mistake during bear markets is converting all or most assets to cash as a presumably safe haven. On the surface, this seems like a prudent strategy, since cash isn't actually losing money and you can stop the bleeding. But if cash assets are earning you an interest rate of 2 percent, and inflation is running at 2 percent-your seemingly safe investments are only breaking even. Moreover, market recoveries happen quickly, usually too quickly for the everyday investor to react to with any accuracy. You certainly don't want to be exclusively in cash when the rebound begins and miss the big upswing that generally follows most bear markets.

Markets always cycle

It may seem a bit yogi-bearish to say it, but long-term investing works over the long term. Over the short term, anything can happen. Consider the typical business cycle, which, as it relates to the stock market, usually consists of three phases:

Expansion: when the economy is growing and taking stock prices with it. As with all market phases, the pendulum usually swings too far, resulting in overheated stock valuations.

Recession: when the economy cools and stock prices fall. Here again, market movement is excessive, and stock prices decline to an undervalued level.

Recovery: investors again begin to look forward to increases in corporate earnings and a corresponding bounce in stock prices. Stick with your investments throughout the various cycles and you will be rewarded for your patience. Try to chase the ebbs and flows of the cycle and you're in a dangerous guessing game.

"Our patience will achieve more than our force."-- Edmund Burke

Principles of bear market investing

How, then, should you invest, and what should you expect in a bear market? Consider these the three fundamental principles of bear market investing:

• Own quality.
• Don't be afraid to invest in struggling investments. If you're investing for the long-term, you want to employ a system of buying low.
• Re-allocate your portfolio regularly to reflect an emphasis on diversification and long-range thinking. Don't get greedy. As the market recovers, take profits on a systematic basis. If the market keeps rising as you engage in rational profit taking, so what? When you're happy with your results, it doesn't matter what the broader market is doing. And if you can't rebalance yourself then make it automatic. Don't let your expectations be distorted by those years of uncharacteristic gains; they're just as aberrant as years of dismal loss.

A successful asset allocation strategy requires the commitment to keep a designated percentage of assets invested in their respective classes, regardless of the current performance of those classes. Inevitably, some asset classes and subclasses perform better than others over the short term. But today's underperformers are tomorrow's stars.

Remember:

"An optimist is a person who sees a green light everywhere, while a pessimist sees only the red stoplight. The truly wise person is colorblind." -- Albert Schweitzer