How Do I Protect My Money in a Bear Market?

Photo by James Balog/Getty Images

Welcome to the bear market of 2008. If you’re like most investors, you’ve watched the price of your stocks and mutual funds go down, down, down and asked yourself, “Why didn’t I sell?”

The answer is that you were probably abiding by the Golden Rule of Investing: “Invest for the long term. When the market falls, don’t panic. The market will recover.”

If you have, indeed, been following the rule, you’re not alone. Despite recent market turmoil, most mutual fund investors are sitting tight, according to Brian Reid, chief economist at the Investment Company Institute, the trade association of American investment companies. “People are reluctant to make new investments, but they tend to hold what they already have,” he says.

Still, the validity of the “buy and hold” strategy has long been a subject of debate in the financial world. While the advice may be easy to follow when you’re 50 or 60, it’s a lot harder when you’re 70 or 80 and uncertain of whether you have enough time to wait.

“Our advice tends to be: Stay in the market,” says Ned Notzon, chairman of the asset allocation committee at the mutual fund company T. Rowe Price Associates. “The markets will recover eventually and you’ll be rewarded.”

What’s more, Notzon adds, behavioral research shows that investors are very likely to sell after stocks go down but not likely to buy back­—until long after stocks have gone up.

Notzon suggests that investors can protect themselves against bear market losses by buying shares in bond funds or in balanced stock-and-bond funds. During a market downturn, he says, these funds tend to suffer less than purely stock funds.

Critics of the buy-and-hold philosophy can be scathing in their rejection. “I believe that ‘buy and hold’ is a disaster,” says Martin D. Weiss, president of Weiss Resarch and editor of the Safe Money Report newsletter. “Primarily, it’s a sales pitch disguised as a piece of advice. Brokers have a strong incentive to get you to buy and a strong incentive to stop you from selling.”

Investors can’t simply wait for markets to recover, Weiss says. “The reality is that bear markets can last for years. And during all those years, your money is dead in the water.” You need to be flexible, he adds, and make changes in your portfolio when conditions change.

If you believe a recession or housing downturn is coming, adjust your portfolio. “That’s a time to significantly reduce your exposure to stocks,” Weiss says. “That’s very rational behavior. You don’t want to trade every day. But don’t wait until your stock is worth 10 percent of what you paid for it,” he says.

Instead, investors can implement their own hedging programs, Weiss says, by investing in exchange-traded funds that allow investors to protect their portfolios against price declines. For instance, when the price of the Dow Jones Industrial Average falls, the price of such an “inverse” fund based on the Dow will rise.

A Dilemma for Boomers

Golden rule supporters say that selling stocks when the market goes south is a bad idea because it means you have to be right on the price twice: Once when you sell and again when you buy back in. That may be true, but they rarely tell you how much money you can lose by hanging on.

While bear market losses concern all investors, they particularly worry boomers who are within five or 10 years of retirement. My 52-year-old son, Larry, is an example. A lawyer and businessman, Larry lost faith in the buy-and-hold idea in the late 1990s when he invested his retirement money in Lucent Technologies, then the darling of Wall Street. When Lucent was reported to be using dubious accounting practices, its high-flying stock crashed. “I kept telling myself, ‘It will come back,’ ” Larry says. “But it never did.” Two years later, the stock was selling for 55 cents a share and Larry lost his investment.

Larry also remembers the tech bust of 2000. When markets finally “recovered,” hundreds of tech companies were gone, along with the money invested by their shareholders.

In 2007, Larry was watching the housing bust and the subprime mortgage mess. Oil and gasoline prices were rising and the economy was slowing. “Even with all the bad news, the market kept hitting new highs,” Larry says. “I knew the day of reckoning had to come.”

So, in May 2007, Larry sold his shares in a fund that tracks the stock performance of the S&P 500 companies. The fund, formally known as the SPDR S&P 500 ETF, trades on the American Stock Exchange under the symbol “SPY.”

Larry sold his shares at $149.75. Afterward, the markets continued to climb, and in October the fund reached a 52-week high of $157.52. Undeterred, Larry stayed out of the market and waited.

When 2008 dawned, the markets turned down sharply. By June and July, the collapse of Bear Stearns—followed by widespread meltdowns in the financial sector—sent stocks into bear market territory.

On July 15, SPY dropped to a 52-week low of $120.02. Fifteen months after selling his shares, Larry began to move back into the fund, buying shares at $121—about 19 percent below where he had sold them.

“I understand that the market may yet move lower,” Larry says, “but I plan to keep buying. Even if I have to buy and hold for quite a while, when the market goes back to the October 2007 highs,” he says, “I will still be at least 20 percent better off than people who did nothing during the downturn.”