How to Not Get Blindsided by a Bear Market

A friend of mine is very wealthy. Yet every time the market shimmies, he asks me if he should get out.

“It depends on your tolerance for risk,” I explain to him. I walk him through a series of questions to help him figure out whether he is comfortable staying in the market.

The stock market is at all-time highs. The S&P 500 is on the doorstep of reaching 7,000 for the first time ever, and the Dow is closing in on 50,000. That makes me think that many investors are not ready to handle a downturn or a full-blown bear market.

Please note, I’m not predicting one. I’m just saying that eventually a bear market will occur (great prediction, Nostradamus).

Should there be a sell-off in the near future, it could be ugly, as investors are ill-prepared to handle the pain that the market doles out from time to time. After years of prices mostly moving higher, I’m concerned we’ve forgotten how to weather a market that is going down. In fact, in the past year, every time the market has slipped, say, 3%, I’ve gotten emails asking if it’s time to bail out.

These three questions will help you deal with the next bear market.

1. When do you need the money that’s invested in the market?

If you don’t need the money that’s invested in stocks for another 10 years, then a bear market – even a nasty one – shouldn’t be much of a concern. It won’t be fun, but the stock market almost always goes up over a 10-year period. In fact, the only way you would have lost money over 10 years would have been if you had sold during the height of the Great Depression or Great Recession. Even if you had bought at the highs in 2007, right before the 2008 financial collapse, and held for 10 years, you would have made money.

Every single correction and bear market in history – and I do mean every single one – has been followed by a new high.

But if you’ll need the funds that are invested in stocks within the next three years, take them out now – not because we’re at all-time highs or because I’m worried about a bear market, but because you can’t afford to be exposed to short-term risk. Anything can happen in the market over three years, and knowing that an important deadline – such as a tuition bill – is coming up while the market is falling will make you crazy. You’ll likely end up selling at the bottom when the panic sets in.

So sell your stocks if you need the capital within three years.

2. Do you have trailing stops?

Trailing stops will protect your gains and capital if things go wrong in the market.

The best aspect of a trailing stop is that it removes emotion from your decision to sell.

It’s so easy to freeze up – to ignore your own rules – when the market tanks. “The stock was just at $50. Now it’s at $47. If it gets back to $50, I’ll sell it,” you say to yourself. And then $47 becomes $45, which becomes $40…

Trading with emotion is dangerous and can cost you a lot of money.

I recommend 25% trailing stops. If a stock is trading at $100, your stop would be $75. If the stock rises to $110, your stop climbs to $82.50.

A stop will protect your profits in a rising market and will keep your losses small during a correction or bear market. The key is to honor your stop and not remove it when the stock starts getting close to the stop price.

If you use a trailing stop, you’ll get out when things start getting messy, and you’ll have plenty of capital to put back into the market when you’re ready.

3. Can you handle a downturn emotionally?

Answer this question honestly. There’s nothing wrong with saying that a sell-off in the market scares the bejesus out of you.

If that’s the case and the answers to the first two questions don’t provide comfort, take your profits now and invest in something much safer like Treasurys, CDs, etc. You won’t get nearly the same return over the long term as you would in the stock market, but you’ll have much less stress – and that’s important.

Stress about financial matters breaks up marriages, causes health problems, and is miserable to live through. We’ve all been there.

So if knowing that your time horizon is long enough to make back potential losses (and that trailing stops will protect your capital) isn’t enough to keep you calm, don’t expose yourself to the market or that stress.

Having a plan in advance of a bear market will make it much easier to withstand when it finally arrives.