“The market is going to crash!” You have probably been hearing this for the last 4-6 years, or even longer. The market always seems to be hitting new highs, and it never seems to be a good time to invest.
However, time in the market is better than timing the market. This saying means that today is the best day to invest, besides yesterday. We have to prepare ourselves for good days and bad days on the market.
Being an investor, vice a trader, gives us the benefit of long-term thought processes. Building the mindset of an investor means that we know how to make money whichever direction the market heads.
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I want to discuss how we can prepare ourselves for a prolonged bear market. I briefly touched on the topic in my article “How to Prosper During the Next Recession.” Today, I want to perform a deep dive into what we can do on the stock market to best position ourselves for the next downturn.
Let’s start with some definitions. Wall Street considers a market correction when the market moves downward 10% from its recent highs. A bear market is when the market moves downward 20% from its recent highs, usually over a few months to a year.
The stock market, as with most asset classes, moves on a boom/bust cycle. Understanding these cycles is vital to your overall investing performance. The boom/bust cycle is outside of the scope of this article, but I took a note to write about in my Become a Bonafide Investor series.
Right now, we know that the market is going to correct itself at some point. We can try to predict the catalyst, but nothing in investing is certain. Who could have predicted the pandemic correction of 2020?
Positioning ourselves. There are three ways to position ourselves: education, hedging, and cash. We will need to leverage each of these to have the best chance of thriving (not only surviving) in the next crash.
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Education. Education is the most important aspect of preparing for the crash and bear market. Each asset class (commodities, REITs, housing, consumer products, automobiles, etc.) has its own boom/bust cycle. They also have their own catalyst.
Let’s look at sectors inside Real Estate Investment Trusts as an example. Mortgage REITs buy paper mortgages (loans). They make money by leveraging the difference between interest rates and the 10-Year Treasury bond. When interest rates spike higher, they may suffer. So we need to keep our eyes on the Federal Reserve to see how they will adjust interest rates.
Commodities do well in inflationary periods because the prices of goods rise. However, they are highly cyclical (meaning they move in cycles). Look at the cost of oil over time. If we want to leverage commodities, we need to understand their various cycles and find a way to get into a position to benefit from a bear market. We may even decide to buy during the recession.
The best thing I can say about education is to become a lifelong learner. Read SeekingAlpha daily. Understand how growth stocks react to a downturn, as well as blue-chip stocks. Some stocks and securities are more likely to cut their distributions (dividends) during a recession, such as banks. Get smart!
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Hedging. Now that we are reading every day, we also need to put physical measures in place to hedge against downturns. Hedging is “to limit or qualify something by conditions or exceptions.” In layman’s terms, it is to use a procedure, process, or security to protect your investments.
One way to hedge is with options trading. If you are tracking the stock market closely and have a few positions with high capital appreciation, you may want to protect them by buying a put option.
A put option gives the buyer the right, not the obligation, to sell a stock. So if my XYZ stock is sitting at $100, I can buy a put option for the strike price of $90. If the price drops to $80, I will want to exercise my right to sell the stock to the seller at the agreed-upon price of $90.
Bonds can be a way to protect yourself from total stock market annihilation. As we saw during the pandemic, bond funds went to the toilet just a much as everything else. However, they recovered quickly and shot to an all-time high before growth stocks made a comeback.
I like to dollar-cost average into bond funds through the year. When the market crashes, I expect my bonds to bottom out; however, I hope they will recover quickly. I can sell them as they top out and convert that income into buying opportunities if they do.
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Gold, and to a lesser extent cryptocurrencies, are also hedging against market downturns. Usually, during bear markets, recessions, and depressions, people lose faith in the US Dollar. We can hedge against the loss of confidence in the dollar by holding gold, silver, and cryptocurrencies. We don’t have enough data about how cryptocurrencies react during a bear market to speak confidently, yet.
Cash. Cash provides us with a few options to protect us against a bear market. The first is it stops us from selling our stocks. The last thing we want to do during a downturn is sell anything.
If we are living off dividends, we will need a significant cash cushion to protect us from the sequence of returns risk. I wrote about the sequence of returns risk in Living Overseas Passively 103. We need at least two years of expenses in cash. I said expenses, not “perfect living conditions.” We may spend $5,000/month when comfortable but only truly need $2,000/month for expenses.
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Next, cash allows us to buy stocks at a discount. If we are doing our research, we should know what stocks are selling for great prices. I remember seeing McDonald’s selling for $150 during the pandemic (it was $218 before). Now, MCD trades at $241.
I wasn’t in a position to buy McDonald’s at the bottom. However, next time, I will be ready and able to purchase great blue-chip stocks, preferred shares, and closed-end funds at a discount. Cash is king. It can protect us from selling shares and ruining our retirement with a poor sequence of returns. Cash can also give us the option to go shopping while everyone else is panic selling.
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Conclusion. I would love to dig deeper into this topic because it is a vast ocean of possibilities. However, knowing what kind of investor you are in the first key. If you are a blue-chip dividend growth investor, you should know how to hedge against their reactions in a downturn.
Suppose you invest in commodities, real estate, closed-end funds, index funds, bonds, etc., know what to do when trouble strikes. If you invest in capital gains, maybe options are your best hedge. There is no reason to “spray and pray” in the stock market.
If you feel the market is too high, dollar-cost-average 50% of your money into the market, and save 50% in cash or USDC (at 9% interest!). There are so many ways to win that we shouldn’t be scared of a market crash; we should be ready!
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Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. All Right Reserved Military Family Investing
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