What Smart Investors Do In Bear Markets
Bear markets are scary times for investors. There is so much uncertainty in the air, and as we all know uncertainty can lead us to make some irrational decisions. However smart investors have a clear strategy during bear markets. Smart investors not only survive through a bear market, but they thrive off of it.
1 - Don’t Try To Time The Bottom
The number one thing smart investors do during a bear market is actually what they don’t do. They don’t try to time the bottom. No one, and I mean no one knows when and how a bear market will end. Even the smartest economists constantly miss their forecasts. Of course this doesn’t stop many from trying. One of the most famous investors, Warren Buffet is famously quoted as saying:
Be “fearful when others are greedy, and greedy when others are fearful.” - Warren Buffert
Many people take this at face value and leap to the conclusion that Mr. Buffett has found a magical way to identify when the market is at its rock bottom. He has found the perfect formula for timing the market and he knows when to sell and when to buy for maximum profit. However this is far from the truth. Instead he is on record speaking to the foolishness of trying to time the market.
“The Dow started the last century at 66 and ended at 11,400. How could you lose money during a period like that? A lot of people did, because they tried to dance in and out.” - Warren Buffert
No one knows when stocks will bottom because markets in freefall are mainly driven by a combination of emotion and herd psychology. Something no one can predict with certainty. It’s always possible that it can get worse from current levels. Or it can even get better. In mid-October of 2008, Warren Buffett penned an op-ed for the New York Times entitled, “Buy American. I am.” At that point the S&P 500 was nearly 40% off its highs and in the midst of the worst financial crisis since the Great Depression.
“The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary. So … I’ve been buying American stocks.” - Warren Buffet
Many people constructed from this statement that Warren Buffet was signaling the bottom of the market. That we had hit the bottom so Warren was buying more American stocks for a hefty profit. However, what many don’t talk about is that after this op-ed, the stock market fell an additional 30% and didn’t hit the bottom under March of 2009. Five months later.
Even the world’s greatest investor could not nail the bottom of a falling market. And that wasn’t his intention with the op-ed. He was just highlighting the fact that despite how scary the market may look, we shouldn’t be afraid to invest. Therefore he was buying regardless because he had confidence in the American economy. Of course it helped that he bought it on the way down and made a hefty profit from it.
Smart investors don’t spend time trying to time the bottom. They don’t waste time trying to read the market’s tea leaves. Instead they buy when the market is up and when the market is down. Because in the long run, that is how you win.
2 - Book A Loss
The number two thing smart investors do during a bear market is to book a loss. This initially may sound a bit contradictory given I advocate so much for buying and holding. Why in the world would you want to sell during a down market? But hear me out. The reason you want to book a loss during a bear market isn’t to spend the money, but to lower your taxable income.
During bear markets, smart investors use the decline in the market and deploy a strategy that is more commonly called “tax loss harvesting.” The basic idea behind tax-loss harvesting is that you sell investments that have decreased in value and then use the losses to decrease your income taxes. And this works whether you are invested in VTSAX, FSKAX or ABCDF.
Let’s take a look at an example. Let’s say that you bought 100 shares of Vanguard Total Stock Market Index for $100 last year and now it is worth $90. Your $10,000 investment is now worth $9,000 and you have $1,000 worth of unrealized losses in your portfolio. If you sell your shares of VTSAX and take the $1,000 loss, you can then use that loss to cancel out capital gains or lower your taxable income by a maximum of $3,000 per year. Better yet, any losses in excess of $3,000 can be carried forward to future years.
But you don’t want to just take the loss and spend your $9,000. You want to have the cake and eat it too by staying invested. After you sell your shares of VTSAX for $9,000, you want to use that money to buy shares of an index fund that performs similarly to VTSAX but is different enough not to be considered a wash sale. A wash sale is when you sell shares at a loss but buy substantially identical investments 30 days before or after the sale. If you sold your shares of VTSAX and then immediately bought more shares of VTSAX, the transaction would be considered a wash sale and you wouldn’t be able to use those losses to reduce your taxes.
Therefore, rather than immediately repurchasing shares of VTSAX, you should instead purchase shares of a fund that performs similarly but tracks a different index. A good share you can buy after you sell VTSAX is VFIAX, Vanguard 500 Index Fund. A fund that tracks the S&P 500 instead of the total market. Or if you want to deploy that money to rebalance your portfolio, you can purchase additional international index funds or bond index funds. Booking a loss sounds counterintuitive to making money in the market. But if you are a smart investor you can use the downmarket to your advantage to lower your taxable income.
3 - Roth IRA Conversion
The number three thing smart investors do during a bear market is to convert a traditional individual retirement account into a Roth IRA. Or simply known as Roth IRA conversion; moving assets from a traditional IRA to a Roth IRA. Roth IRA is one of my favorite tax advantaged accounts because of its tax benefits.
Your money in a Roth IRA grows without being currently taxed, just as in a traditional IRA. However withdrawals from a Roth IRA are tax-free, unlike in the traditional account, where your payouts are typically taxed at your ordinary-income rate. To be completely honest we don’t know what the tax landscape can look like in the future.
New politicians might choose to increase our tax rates in order to generate more money for the government. Therefore the more we can protect ourselves from this uncertainty the better in my perspective. Roth IRA is great in this regard, because it protects us from any future tax changes.
Another benefit to a Roth IRA is that we can pass our Roth IRA to our children. They will be able to own and withdraw from it tax-free, effectively extending your investment lifetime for some years beyond your own. Of course you want to think hard about how much you want to leave for your kids, but the option is there.
During normal time, the main deterrent to converting a traditional IRA to a Roth is that the conversion is taxable at your ordinary-income rate. When you convert your traditional IRA to a Roth, you are choosing to pay tax today on the amount you convert. But when we are in a bear market where our portfolios are down 20% or more, the amount on which we will be taxed is significantly lower. The dollar value of the Roth IRA is lower due to the stock market decline, which means we pay less taxes on the conversion than we would have when stock prices were higher at the market peak.
Once again, smart investors see opportunities when everyone else is fearful. Bear markets present great opportunities like the Roth IRA conversion if you know what to look for.
4 - Keep Cash
The number four thing smart investors do during a bear market is that they keep cash. And most often, a lot of it. Bear market is scary because of its uncertainty. We don’t know if it will be 3 months or 3 years. We don’t know if the job market will be impacted and if our portfolio will recover in time. That is why we all need a strong reserve to weather this uncertainty. And cash is really your best ammunition.
Yes, cash is one of the lowest returning asset classes. Just look at your checking account. Are you making more than 0.03% in interest? Well if you are, you are doing better than the average. However don’t let the low interest rate blind you to the power of cash. When you have 6 to 12 months of cash in your bank account it provides you a solid protection against market uncertainty and volatility. You aren’t pressured to sell, so market volatility doesn’t impact you.
Most often people panic in a bear market because they don’t have enough cash in their bank account. They don’t have enough cash to handle their near term obligations and goals. But when you have cash, it keeps you calm and clear headed because you laid the groundwork for exactly these kinds of times. Instead of a knee jerk reaction, smart investors with cash are able to handle the bear market; both financially and emotionally.
Another advantage to holding cash during bear markets is that cash allows you to take advantage of opportunities. Let’s say that you’ve been dragging your feet about opening up that 529 college savings account for your kids. Well if you are in a bear market and you have sizable cash in your bank account, this might be the best time.
Don’t just take my word for it. Notably, the smartest investors in the world Warren Buffet and Charlie Munger live out this strategy. Berkshire Hathaway, Warren Buffet and Charlie Munger’s primary holding company for their investments is known for always holding more than enough cash. In their 2014 Berkshire Hathaway annual report that they vowed to never to keep less than $20 billion dollars in cash.
When COVID-19 caused a market crash in 2020, Berkshire Hathaway decided to hold more. Actually way more. $137 billion in cash. And their cash strategy has served them quite well when it comes to taking advantage of market opportunities. During the financial crisis of 2008, Warren Buffett was able to pump $5 billion into Goldman Sachs shortly after the Lehman Brothers collapse. Serving as a massive boost of confidence for Goldman Sach and helping to stabilize an already shaky market. However, it also netted Buffet a hefty profit of approximately $3 billion - all because he had the cash to do so.
5 - Stay The Course
The number five thing smart investors do during a bear market is the most obvious and also the hardest. And that is to stay the course. Jack Bogle, the founder of Vanguard considers the statement, “Stay the Course” as one of the greatest rules of investment success. He believes it so much he even has a book titled after it. His last book before he passed away sadly in 2019 at the age of 89.
It is not easy to wait it out during a bear market. The market and the future seems uncertain and it feels like we need to be doing something. Selling and maybe waiting for the market to rebound. However smart investors do exactly the opposite. They don’t do anything. They have mastered the art of patiently waiting.
It’s not easy watching headlines blare all day about the market crashing and listening to friends speak about selling everything off. However, investing is a game best played long. What you do during these downturns will define your performance over time. Ignore the day-to-day fluctuations in the stock market and focus on the long-term growth of the US Economy.
