At a time when stock markets across the globe are making new record highs, planning for a bear market may seem like a rather strange thing to do. After all, the outlook for the global economy is relatively positive and this could lead to higher earnings growth as well as increased valuations.
However, a bear market is never far away from a bull market. As such, while aiming to generate high returns is a worthwhile pursuit, planning for a more challenging period for share prices could be a worthwhile endeavour.
Of course, for a bear market to come into existence, share prices must fall by 20% from their peak. Therefore, once this has happened, an investor may have already lost 20% of the value (or more) of their portfolio.
During the period where share prices are falling but it is not technically a bear market, there are usually a wide range of views on the future for share prices. Often, the general consensus is that the fall in share prices is a ‘dip’ or a ‘correction’, and that the bull market is set to resume in the near term.
As such, many investors will focus on the profit potential that may be available now that share prices have fallen by as much as 20%. Certainly, wider margins of safety may be on offer. But if a full-blown recession takes hold as was the case in the financial crisis, then the losses in certain sectors could be much higher.
Therefore, during share price declines and even during a bull market itself, investors may wish to focus on risk at least as much as reward. Certainly, a stock price may be 5% cheaper than it was last month, but this may not necessarily mean that it is good value for money on a long-term basis. Similarly, a company with high debt levels may be in the process of deleveraging, but if it is unable to reduce borrowings to a sustainable level before the next recession, then it may run into severe difficulties.
By focusing on the potential downside and risk of loss as much as the upside potential, an investor may be able to boost their long-term portfolio performance. While difficult to achieve in a bull market where optimism is high, being realistic about the potential returns on offer based on the track records of stock markets could be a useful means of developing increased discipline when it comes to investing.
The longer the current bull market lasts, the more severe the next bear market is likely to be. It could present a superb buying opportunity for investors that more than offsets any opportunity cost of holding cash in the meantime. Therefore, while it is tough to ‘miss out’ on gains from record share price movements, doing so to some extent may be the best option for long term investors.