Many investors are tempted to sell when the market moves lower or media pundits talk of an imminent decline. Of course, investors that sell everything run the risk of incurring a lot of cost and potentially missing out on any upside. Studies of financial market transactions have consistently shown that investors are exceptionally bad at trying to time the market, which has led to the growing popularity of passively managed index funds.
In this article, we will take a look at how investors can prepare for a potential bear market without selling everything and running these risks.
Why You Shouldn’t Sell Everything
Most people have heard stories of those who sold at the top of the 2000 tech bubble or the 2008 housing bubble, but the data shows that most people tend to lose money when trying to time the market. According to Schwab, the best strategy to optimize returns is to immediately invest in the market. In their study on market timing, perfect timing only moderately improved performance, while poorly timed investments were much better than no investment at all.
Returns on $100,000 by Strategy
The Schwab study looked at how much hypothetical wealth each type of investor would have accumulated between 1993 and 2012, but the findings were exactly the same in 58 of 68 separate 20-year periods dating back to 1926. During the ten exception periods, the ‘invest immediately’ strategy came in second four times, came in third five times, and tied for fourth one time, during the 1962-1981 period when equity markets were exceptionally weak.
Taxes are another reason that investors should avoid selling everything in anticipation of a bear market. While long-term positions are taxed at capital gains rates, selling short-term positions that have been held for less than a year can trigger ordinary income taxes.
Regular Contributions with Hedging
The Schwab study suggests that investors should begin by making regular contributions into investment accounts without trying to time the market. By doing so, investors can maximize their returns over long periods of time regardless of short-term market performance. The easiest way for most investors to make regular contributions is to set up automatic deductions from their bank accounts on a monthly or quarterly basis.
SPY Chart with Brexit Vote
The only exceptions to the rule are when investors have a shorter time horizon or would like to mitigate an immediate risk. For example, the Brexit vote was set to occur on a specific date and nobody knew how it would affect the markets. Investors with a short time horizon could have hedged against this short-term risk in order to mitigate the potential for losses. Investors that are withdrawing capital within a year or two may also want to hedge against risk.
Using Options to Hedge Risk
Stock options are the easiest way to hedge against a bear market without selling. In essence, options give investors the right – but not the obligation – to buy or sell a security at a predefined price and time. Put options provide the right to sell, while call options provide the right to buy. There are many different options strategies, but investors who don’t usually use options may want to stick to some simple and proven methods to hedge against risk.
A protective put option strategy is the most common for those looking to protect their portfolios against downside. By purchasing a put option for the number of shares owned, investors can create a price floor for their equity position over a period of time.
For example, an investor concerned about their 100 shares of the iShares MSCI Emerging Market ETF (EEM ) could buy a single put option that gives them the right to sell 100 shares at a given price. If the ETF rises in value, the investor loses the premium paid to secure the put option, but if the ETF falls in value, the investor has the right to sell their shares at a certain price – or the option itself for the equivalent value.
Since investors aren’t buying and selling stock, there’s no risk of generating short-term capital gains that could become costly during tax season, but they still gain a price floor that protects them in case of a bear market. There is also no limit on potential upside, which means that investors won’t suffer from the potential opportunity costs of being out of the market.
The Bottom Line
Most investors shouldn’t try to time the market, based on data from a recent Schwab study, as well as a plethora of other studies. Instead, investors concerned about a pending bear market may want to consider using stock options as a way to hedge against risk. This approach helps control risk factors in the short-term, while avoiding potentially expensive tax consequences and the potential opportunity costs of being out of the market.
