When prices drop and stock markets decline, they are likened to a bear that turns tail and retreats into its cave to hibernate.
Investing in a bear market presents a challenge for every investor, and those with ETF holdings in their portfolio are no exception.
Because they are traded like stocks, Exchange Traded Funds are subject to many of the same investment risks.
But you should remember that market corrections are an inevitable part of investing, and the best way to learn how to invest in ETFs during a down market is to first acknowledge this fact and resist the urge to panic.
Here are six proven strategies that may not only help you to survive a bear market, but can allow you to come out of one more strongly positioned than you were going in.
1. Sell Your Current ETF Holdings to Buy Another
Knowing when to sell your funds is one of the most difficult elements of ETF investing.
The tendency for many investors during a declining market is to hang onto their shares no matter what, with the intent of waiting things out until the market improves.
The problem with this approach is that full recovery may be a long time coming, and the damage to your portfolio in the meantime can be significant.
But if you employ the same rational thinking to your selling decisions during a bear market that you do during better times, you can protect yourself from taking on any more loss than is necessary.
One option is to sell your current ETF holdings and use the proceeds to purchase another, low-risk type of investment for the duration of the downturn. Or you could simply switch your funds out for those that are known to be less volatile overall.
Neither of these strategies is necessarily designed to have you coming out ahead of the game when the market finally corrects itself, but they do present some viable ways to protect and maintain your financial position when investing in a bear market.
2. Buy More ETFs at a Lower Price
A somewhat more aggressive approach to battling your way through a bear market is to take advantage of the abundant opportunities to purchase high quality ETFs at bargain prices.
If you’re a long-term investor with funds to spare, you can actually benefit from a market downturn because many other investors will be in panic mode, and will be selling off their holdings to prevent losses.
Take advantage of this chance to re-evaluate your portfolio in light of your investment goals, and to increase and rebalance your ETF holdings by buying low during a period when other investors are selling low.
3. Allocate Your Investments to Stay Diversified
Efficiently allocating your ETFs is not only the best way to take full advantage of their diversification potential, it’s a strategy that can protect your portfolio from potential market downturns before they occur.
ETF investing allows you to benefit from a wide exposure to various markets and sectors, and investors with a well-diversified portfolio will always be impacted less during a bear market than those with individual stock holdings only.
When evaluating your investments in preparation for a down market, you should consider whether any of them expose you to sectors or assets that tend to perform badly when things turn ugly. Some ETFs are inherently less volatile than others because of the sector they represent, and these can make a great addition to your portfolio for their ability to help balance out returns during periods of unpredictability.
In addition, there are some market sectors that actually perform better during bear markets, including those that represent consumer staples, and you may want to consider investing in these ETFs to help reduce risk.
Finally, try to cover any allocation shortcomings in your portfolio with ETFs that have a tendency to outperform the market, and with ETFs that are designed to either short sell the market as a whole, or just those sectors expected to under-perform during a downturn.
4. Apply the Market Sector Rotation Strategy
Applying a market sector rotation strategy to your investment portfolio is another effective ETF investing plan that can not only help to protect your holdings during a bear market, but can actually increase your potential returns at any given time during the economic cycle.
Because the economy tends to follow a repetitive cyclical pattern as it moves in and out of recession and growth periods, you can adopt a practice of weighting your ETF holdings toward whichever sectors have been shown to perform best during various phases of this cycle.
ETFs represent all of the major market sectors, and so lend themselves naturally to this rotation strategy by allowing you to focus on those businesses that have a tendency to shine just before, during, and right after a bear market.
As an example, sectors that usually perform well going into a market decline include healthcare and utilities. As a market bottoms out, financial and technology funds are often among the best performers, while industrials and base metals, followed by energy, are some of the first sectors to recover after a recession.
As an alternative and opposite method for making the most of a bear market using the sector rotation strategy, you could consider buying inverse ETFs that are carefully designed to short sell those sectors expected to perform poorly during a decline.
5. Short Sell Your ETFs
Incorporating hedges into your ETF investing strategy during a bear market is not only an effective way to mitigate risk, it can also help lead the way to potential profits.
One common type of hedging technique is to short sell ETFs in order to make a profit when they drop in price.
Short selling involves the opposite approach to buying ETFs that you anticipate will go up in price, because instead of buying low and then selling high, you ‘borrow’ shares you don’t actually own to sell high and then re-purchase low, in order to pocket the difference after their prices have declined.
Because short selling is based on the expectation that a security’s price will drop within a certain period of time, it’s a strategy that lends itself well to a bear market, especially since many investors only every adopt a long position (buying in hopes of prices rising) in their portfolio holdings and so have a tendency to start selling off shares when markets decline.
In some ways, short selling can be viewed as an opportunity to double your chances for profit when it’s implemented alongside a strategy for investing in ETFs that perform well during a down market.
Short selling is not without risks of its own, however, and you should become familiar with these in advance.
For example, if you happen to be short in a stock at a time when it pays out a shareholder dividend, you will be responsible for paying that dividend.
But the biggest risk lies in the fact that, while your profits from short selling are finite, since a stock price can’t drop below zero, your liability is infinite because prices could theoretically continue to rise indefinitely.
This is not really as frightening as it sounds, however, since you do have the ability to cut your losses and get out of your short position at any time, by simply buying back the shares you are obligated to purchase.
Using the added protection of stop-loss orders can allow you to set selling prices in advance, and they’re highly recommended when short selling your ETFs.
6. Invest in Inverse ETFs
Inverse ETFs are another way to take advantage of short selling during a bear market.
These funds are specifically created to track the indexes of various markets and sectors, but with the intent to profit from declining rather than rising prices.
Like regular short selling, inverse ETFs allow you to hedge your portfolio’s risk exposure while taking advantage of potential profits.
But unlike short selling on your own, buying inverse ETFs does not require that you set up a margin account to facilitate the borrowing of shares, and you get to benefit from the fund’s professional management.
Inverse ETFs provide an alternative bear market strategy that you can implement in place of liquidating your holdings, or hanging onto your long positions in the hope that they will recover.
To be most successful however, this strategy should involve buying inverse ETFs that run closely opposite to those you already own, and a good rule of thumb is to adopt a 75% long and 25% short position for each fund.
It’s also important that you remain aware of any market changes while you’re invested in inverse ETFs, so you can sell them in a timely fashion when prices begin to recover.
The Bottom Line
Although investing in a bear market will test your ability to remain objective and agile as prices fall around you, ETFs offer some great down-market strategies that provide a number of ways to reduce negative impacts on your portfolio.
If you can keep your long-term investment goals in mind while making use of these methods, you’ll soon find yourself sleeping much more soundly at night.