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Course 407
Bear-Proofing Your Portfolio

Introduction

The investing world's jargon is sometimes too colorful. For example, there are "bull markets," or periods in which a particular type of investment does exceptionally well. Less pleasantly, there are "bear markets," or times when a particular type of investment performs poorly. Definitions of what constitutes a bull market vary, but a period in which a given market segment drops by 20% is usually considered a bear market.

Now if only we knew when those bears would roar, or what investments would survive the mauling. But because each slump brings its own new twists, yesterday's bear-market hero may not survive the next downturn nearly as well. Besides, even if bear-proofing a portfolio were simple, it may not be smart.

A Bear Is Not a Bear Is Not a Bear

Over the past 20 years, the Dow Jones Industrial Average has slid by 20% a handful of times. That means if you had $100 invested before the slide, it was worth $80 at the end. Each bear attacked in different ways, sometimes doing widespread damage and sometimes focusing on a certain industry or security type.. Technology stocks and funds were the hardest-hit when the Internet bubble burst from 2000 through 2002, while the 2007-2009 bear market was less discriminating, dragging down everything from high-flying growth stocks to commodities to bank-loan funds.

On the other hand, despite recent evidence, high-quality bond funds typically escape major trauma in periods of significant stock-market weakness. Everything else has been less predictable. Small-company funds held up well during one bear market, and then suffered during the next one. Junk-bond funds have wandered all over the map, posting gains in the early bear markets but collapsing in 1990 as the economy weakened and stumbling again from 2000 to 2002 and 2007 through early 2009. Gold has also been mixed: Anyone who came out of the late-1970s bear market believing gold was the place to be on a long-term basis got burned in the early 1980s, when the bear knocked precious-metals funds for a 30% loss. In recent years, however, gold has provided a haven for investors fearing inflation and geopolitical instability. In the new century, cautious investors have flooded the precious-metals category.

Three Varieties of Bear

Many different causes can trigger a bear market, but usually the cause has something to do with the economy. Here are three common causes of bear markets, as well as what types of investments tend to do best in each type of bear market.

Recession. A recession hit the U.S. in late 2007, according to the National Bureau of Economic Research. That's when the spillover effects from the moribund housing market and financial-services woes began to affect consumer spending. What's more, business spending and hiring slowed to a halt as companies pared back their budgets in an effort to slow the deterioration of their profit margins. While inflation remained in check, the economy shrunk all the same.

Firms that deliver inexpensive or staple products, such as food, beverages, cigarettes, and health-care items, tend to do well in a recessionary environment. Other stocks, such as automakers, steel producers, and paper manufacturers--as well as retailers of discretionary goods like clothes and housewares are highly sensitive to economic cycles - hence they are termed cyclicals. High-yield (or junk) bond funds can also be risky when the economy sours, because some companies may have trouble paying back their debtholders.

Rapid Inflation. From the 1960s through the 1980s, many investors viewed inflation as a given. Not even common stocks could protect investors from the price increases of the late 1970s. During normal circumstances, stocks have provided an annual return that has outpaced inflation over the long term, but during the inflationary 1970s, even those stocks struggled. Bonds may also lose value during inflationary environments. as higher prices erode the buying power of their payouts.

As a result, investors in the 1970s flocked to tangible assets such as real estate, art, and gold. Today, investors have even more direct ways to hedge their portfolios against the threat of rising prices, including inflation-indexed bonds and commodities investments, which enable investors to benefit when the prices of hard assets like oil and gas, timber, and metals are on the rise.

Everything else, including regular bonds and stocks not tied to some hard asset such as real estate, tends to lag during periods of rapid inflation.

Deflation. During and after the recession and financial crisis from late 2007 through early 2009, deflation became the economic worry du jour in the United States. Pundits speculated that with anemic consumer spending amid a shaky economy, the prices of goods would drop, sparking a general fall in the U.S. Consumer Price Index - or in other words, deflation. For a variety of reasons, deflation makes it more difficult for businesses to grow their profits, thus weakening stock prices.

Long- and intermediate-term bond funds tend to hold up relatively well in this environment, because their dividends are effectively worth more in this type of economy. A 6% dividend delivers more purchasing power each year if prices are falling by 2% annually. In addition, interest rates often decline during deflationary environments, making already issued bonds with higher interest rates even more valuable. Among equities, look for dividend-rich stocks and the funds that own them.

What suffers? Inflation-indexed bonds, non-dividend-paying stocks, and anything tied to a real asset such as gold, real estate, or commodities do poorly in a deflationary environment. Remember, deflation means a decline in the prices of tangible assets.

What to Do?

Preparing for a bear market is clearly a vexing problem, given the fact that bear markets are usually quite different. Here is what we think:

Don't try to time the market by switching to cash.

Anyone who tries to trick the bear by selling investments and piling up cash will likely suffer less-than-perfect timing and miss out on big stock-market gains. Unless you know something we don't or are extremely lucky, you won't get rich playing the timing game.

Recognize the limitations of bonds and gold.

Given that high-quality bonds and bond funds have evaded the bear in a number of situations, they're a good way to ensure that at least something in your portfolio will perform reasonably well during periods of extreme stock-market weakness. There are some caveats, though. For one, tucking too much money in these bear-market champs is a good way to avoid bull markets for stocks, too. During the bull market of the 1990s, bonds didn't return nearly as much as diversified domestic-equity funds did.

Moreover, these funds aren't completely bulletproof. For starters, being better than everyone else isn't the same as being good. Bonds may have been the best thing going in 1990, but they still lost money as the Persian Gulf crisis unfolded and interest rates spiked. Also, keep in mind that these funds do endure their own separate bear markets from time to time. Investors learned that the hard way in 1994, when long-term Treasury bond funds plunged 7%, and again in 1999 and 2009, when long-term Treasuries lost 9% and 12%, respectively.

Be wary of committing to bear-market funds.

Some funds are explicitly designed to gain money when other assets are losing--so-called bear-market funds. These funds typically bet against an asset class or market sector by shorting that same sector, and many bear funds galloped to robust gains in the recent bear market. However, remember that bull markets won't likely be kind to these funds. It's also worth noting that stocks have increased in value over long periods of time, and bear markets tend to be relatively brief in historical terms. Using a bear-market fund effectively requires that you successfully predict when the market is going to head south, and few, if any investors, have shown any ability to do this consistently.

Grin and bear it.

Let's face it: Investing has its risks, one of which is losing money. It's going to happen from time to time. Diversifying across a variety of fund types and asset classes won't prevent the blow, but it will soften it. Every bear leaves at least a few fund categories with relatively minor injuries.

After setting up a diversified portfolio that meshes with your long-term goals, the best plan is the most obvious one. Stay the course, invest regularly, and promise yourself not to panic when (not if) the market stumbles. The prospect may seem unappealing, but the alternatives can be worse.

Quiz 407
There is only one correct answer to each question.

1 During a bear market:
a. A particular type of investment performs poorly.
b. Inflation rises.
c. There is a recession.
2 During a recessionary period, what usually holds up well?
a. Junk bonds.
b. Cyclical stocks.
c. Health-care stocks.
3 During a period of rapid inflation, what usually holds up well?
a. Hard assets like precious metals and commodities, as well as inflation-linked bonds.
b. Short-term bonds.
c. Foreign bonds.
4 During a period of deflation, what usually holds up well?
a. Gold.
b. Intermediate- and long-term bond.
c. Stocks without dividends.
5 What's the best way to bear-proof a portfolio?
a. Move into cash when you think a bear is coming.
b. Buy only bear-market funds.
c. Build a diversifiede portfolio that owns a little bit of everything.
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