Investing 101: Smarter than the Average Bear

A bear market, defined as a period of declining stock prices where securities fall 20% or more from their recent highs, can seem daunting for investors. However, experienced investors know that bear markets actually present lucrative opportunities to generate outsized returns. In fact, some of the greatest investors like Warren Buffet have made their fortunes by going against the grain and investing during bear markets. This essay will illustrate why bear markets offer better money-making opportunities for savvy investors who take a contrarian approach.

Reasons Bear Markets Offer Better Returns

The key reasons why investors can earn higher returns during bear markets are:

• Assets get mispriced - During bull markets, assets tend to get overpriced as enthusiasm and speculation drive prices up. Bear markets help correct those excesses and realign prices closer to intrinsic value. This allows investors to pick up shares of quality companies at bargain prices. Warren Buffet frequently quotes: "Be fearful when others are greedy and greedy when others are fearful" when referring to investing in bear markets.
• Less competition - With the weakening economy and gloomy outlook, many investors move to the sidelines during bear markets. This means less competition for the best investment opportunities. Skilled investors use this to their advantage to invest in great companies at steep discounts.
• Forced selling creates opportunities - In a rush to raise cash and avoid further losses, investors often resort to panic selling quality assets at irrationally low prices. This environment of forced selling due to redemptions and margin calls allows smart investors to swoop in. Prime examples are funds selling quality stocks at bargain prices to meet client redemptions.
• High-risk premiums - In volatile bear markets, investors demand much higher premiums for investing in stocks versus safe haven assets like bonds. This results in high equity risk premiums, which raises future return potential for stocks selected carefully.
• Shift to value stocks - In bull markets, investors favor high-growth momentum stocks even if valuations are stretched. Bear markets cause a flight to safety and shift preference towards stable value stocks trading at reasonable valuations. This allows investors to build a portfolio of value stocks likely to outperform when the recovery happens.
• Greater rewards for contrarians - Most investors follow the herd mentality. By taking a contrarian approach of investing in solid companies when the outlook seems dire, skilled investors get rewarded when the masses eventually recognize the value. John Templeton summed it up best saying "The time of maximum pessimism is the best time to buy".

Historical Examples

History provides concrete examples highlighting how renowned investors profited tremendously from bear markets by investing in strong companies trading at multi-year lows:

• Warren Buffet - He made big bets on Coca-Cola in the 1987 bear market and American Express in 1963 when the stock was embroiled in a salad oil scandal. His highly profitable investments in those companies were made when they were deeply out of favor.
• John Paulson - He correctly predicted the 2008 subprime mortgage crisis and made over $20 billion for his hedge fund by shorting mortgage securities. The enormous payoff happened as the housing bubble burst leading to the global financial crisis.
• Benjamin Graham - The father of value investing made cumulative returns of over 1000% from 1929 to 1936 by buying stocks trading at huge discounts during the Great Depression era bear market.
• George Soros - In 1992 he risked $10 billion to short the British Pound which was struggling to stay in the European Exchange Rate Mechanism. The Pound eventually dropped out yielding Soros a profit of over $1 billion.
• Jesse Livermore - He correctly anticipated the 1907 and 1929 market crashes. He profited enormously by shorting stocks ahead of the crashes induced by the panics.

In all cases, these investors resisted the crowd mentality and recognized market excesses. By taking contrarian bets, they profited handsomely when the bears took over, and asset values reverted to intrinsic levels.

History has shown repeatedly that bear markets present tremendous money-making opportunities for investors who stay calm and focused. By utilizing a contrarian approach and identifying mispriced assets poised to recover, investors can achieve outsized returns during turbulent times. However, this requires deep research, expertise, discipline and patience to keep sight of the long-term vision when things look bleak. The great investors provide guiding examples to follow for anyone looking to profit by going against the grain during bear markets.

Here are some things you can do to take advantage of the current dip in the equities market:

• Dollar cost average into quality stocks that are trading at discounts. This takes the emotion out of investing and allows buying more shares when prices are low.
• Identify strong companies with solid fundamentals that have been unduly punished. Look for value opportunities with the biggest disconnects between price and intrinsic value.
• Take a long-term view and resist the urge to panic sell. The market will eventually recover. Time in the market beats timing the market.
• Rebalance your portfolio to boost allocations to equities at lower levels in line with your risk tolerance. This sets you up for gains during the eventual recovery.
• Focus on dividend-paying stocks. The regular dividend income can cushion volatility, and reinvested dividends buy more shares when valuations dip.
• Use options strategies to generate income. For example, selling covered calls on existing stock positions can generate extra income during volatile markets.
• Tax loss harvest by strategically realizing losses to offset capital gains. Sell losers to book losses and then reinvest proceeds into stocks you want to hold long-term.

Dollar-cost Averaging

Dollar-cost averaging is an investment strategy that involves consistently investing a fixed dollar amount into a particular investment or asset class over time, regardless of price. The goal is to lower the average share price of the investment. By investing the same amount regularly, you buy more shares when the price is low and fewer shares when the price is high. Over time, this can result in a lower average cost per share.

For example, let's say you have $6,000 to invest in shares of ABC Company. The current price is $50 per share, so your $6,000 would buy 120 shares today. With dollar cost averaging, instead of putting in the full $6,000 now, you could invest $1,000 each month for 6 months. In month 1, you would buy 20 shares at $50. In month 2, if the price dropped to $40, your $1,000 would buy 25 shares. In month 3, an increase to $60 would get you 16 shares. After 6 months, by investing systematically despite price changes, your average cost for the 120 shares would be about $46 instead of $50.

Dollar-cost averaging works best when prices fluctuate over the investment time period. It takes the emotions out of trying to time the market and allows disciplined investing to build positions over time.

Identifying Quality Companies

When looking for quality companies to invest in, especially during market dips, it's important to analyze and understand their fundamentals. Fundamentals include financial attributes like revenue growth, profit margins, debt levels, and cash flows. For example, an investor could look at a potential investment in Home Depot. They would examine metrics like:

• Revenue and earnings growth - Home Depot has demonstrated consistent sales and earnings growth over the past 5 years, indicating solid demand for its products and ability to generate robust profits.
• Profit margins - Gross and net margins have been stable and strong, signaling efficiency and disciplined cost control by management.
• Debt profile - The balance sheet shows manageable debt levels relative to cash flows and assets, meaning leverage risk appears low.
• Cash generation - Home Depot has steady operating cash flows well above capital spending needs, enabling financial flexibility and the ability to fund growth.
• Returns on invested capital - ROIC is healthy and exceeds the company's weighted average cost of capital, highlighting capital allocation efficiency.

After analyzing these and other fundamental factors, the investor can determine that Home Depot has solid, established business fundamentals. This reduces the stock's risk profile compared to peers, especially during broader market declines. The investor can then move forward with greater confidence in their analysis and valuation estimate for Home Depot as a long-term investment.

Long-term Investing

Adopting a long-term mindset is key to investment success. As Matthew Gordon of Crux Investor wisely states, "Most of our money is made in a bull market. Although at the time it doesn't feel like that." His quote highlights that big gains often materialize after periods of decline, when investors with patience and discipline reap the rewards.

Implementing a long-term strategy requires looking past daily market swings and focusing on your timeline of 10, 20 or 30-plus years. Invest regularly in fundamentally strong companies with competitive advantages and growth prospects. Do your due diligence, buy at rational valuations and hold through ups and downs. For example, an investor could build positions in blue chip stocks like Apple, Microsoft and Visa over time. The inevitable bear markets and volatility won't faze you when holding such quality companies. Your portfolio will grow as their earnings and dividends increase over the decades.

Additionally, reinvest all dividends and capital gains to compound your returns. Set stop losses to protect from catastrophic drops but avoid panic selling at the first sign of weakness. Market declines are inevitable but so are recoveries. With a long horizon, you can ride out storms while your portfolio grows. Patience and discipline are key. As Gordon noted, staying invested means you'll benefit from the bull's returns over time.

Rebalancing Your Investment Portfolio

Rebalancing a portfolio involves realigning asset class weights to match a target asset allocation. This is prudent after significant market movements that shift allocations away from their original targets. For example, if an investor had a 60/40 stock/bond allocation, after a stock market dip the equity portion may now be 50% of the portfolio.

The investor could sell some bonds and use the proceeds to buy more equities at lower prices to rebalance. This restores allocations back to 60% stocks and 40% bonds. It ensures the investor maintains their desired risk level rather than passively allowing more concentration in bonds.

An investor should set rebalancing ranges around targets, such as +/- 5%, to avoid overtrading. For instance, with a 60/40 target, they would rebalance if stocks dropped under 57% or rose above 63% of the total portfolio value. They would sell the asset class that is overweight and buy the one underweight to get back to the original 60/40 mix at attractive valuations.

This forces the investor to adhere to their investment plan by buying equities when they are undervalued. It is a disciplined strategy that can enhance returns over the long run. Of course, the investor must consider tax impacts and trading costs when rebalancing. Overall, judicious rebalancing provides a structured way to boost equity allocations during market dips in line with an investor’s risk comfort level.

Dividend-paying Stocks

Dividend-paying stocks can provide tangible advantages for investors building a balanced portfolio, especially during volatile markets. The regular income from dividends not only generates current cash flow, but reinvested dividends allow you to acquire more shares and compound your returns over time. The dividends also signify mature, financially stable companies.

When assessing dividend-paying stocks, investors should look for stocks with steady or consistently growing dividends over time rather than unsustainably high yields. A company like Johnson & Johnson has increased its dividend annually for over 50 years. Investors should examine metrics like the dividend payout ratio to confirm dividends are supported by earnings. The goal is to identify established, high-quality companies committed to providing reliable dividend income and growth year after year.

Stocks in sectors like consumer staples, utilities and telecom tend to pay healthy dividends. Investors can screen for stocks with attractive yields and payout ratios relative to their industry and historical norms. However, they need to be selective - high yield doesn't always equal value. The objective is to build a diversified portfolio of dividend payers with strong underlying businesses that provide recurring cash flow and stability, especially during rocky markets.

Use options strategies to generate income

Options trading provides strategic tools for investors to generate additional income from existing stock holdings, especially during volatile markets. A common approach is the covered call strategy, which entails selling call options against shares you already own.

Here's how it works - let's say an investor owns 100 shares of Microsoft currently trading at $100 per share. The investor could sell a call option on those 100 shares with a strike price of $105 expiring in 3 months. The investor collects the premium upfront for agreeing to sell the shares at $105 if the option is exercised. The premium provides income and reduces the stock purchase cost basis.

If Microsoft stays below $105, the option expires worthless and the investor keeps the premium. If it rises above $105, the shares get called away at that price but the investor still keeps the premium. Either way provides income. The investor does miss out on any gains above $105, but can then sell more covered calls.

With this options strategy, investors generate income while holding the underlying stock. It's lower risk than owning options alone. To start, investors need to own 100 shares of the stock to sell 1 call contract. Then they can evaluate premiums and strike prices to customize the income strategy to match their goals and risk tolerance.

Tax-loss harvesting

Tax-loss harvesting involves selling securities at a loss to offset capital gains and reduce tax liability. This strategy allows investors to minimize taxes while still maintaining their target asset allocation and exposure.

For example, an investor has a long-term capital gain of $10,000 from selling a stock position. They also currently have a stock holding that has declined in value, with a paper loss of $3,000. By tax-loss harvesting, the investor could sell the underperforming stock to realize the $3,000 capital loss. This capital loss would offset $3,000 of the $10,000 gain, resulting in only $7,000 of the gain being taxed.

The investor could then take the $3,000 freed up and redeploy it by immediately repurchasing the same or similar stock they had sold to capture the loss. If they buy back the same security, they just need to wait 30 days before selling again to avoid wash sale rules. This enables them to maintain their overall investment portfolio as desired while harvesting deductible losses to use for tax purposes.

Investors should be strategic in selectively realizing losses in securities they want to dispose of, while still retaining their target asset allocation and holdings. Tax-loss harvesting requires tracking purchase dates and tax lots for each holding, but can meaningfully lower an investor's overall tax burden.