When it comes to the stock market, many investors often feel unprepared to deal with the inevitable dips and bumps in the road that are bound to occur. The majority of individual investors are mere equity holders who take long bullish positions in stocks, mutual funds, and exchange-traded funds (ETFs). When faced with the prospect of a downturn, the most typical response is to just "sell everything" - a tactic that could easily backfire should the market continue to trend upward.
Preparing for a bear market should not always require having to exit the market entirely. One could consider shorting various companies or adding open put positions. Yet not everyone is able to short equities, nor might they have access to options. Indeed, some investors are restrained to having to take on additional long positions or sell out entirely.
However, a more reasonable preparation can be as simple as adding the appropriate hedging position(s) that further diversifies the risk away from assets that are more susceptible to a general downturn. The following four methods hold a varying degree of weight when it comes to operating as a counterbalancing hedge. This allows for additional flexibility to the investor when it comes to portfolio management.
Buy defensive stocks. Adding exposure to equities that have shown their ability to resist volatile swings throughout a recessionary environment can serve as a means of spreading the risk more effectively away from stocks with a higher beta. Large discount retail company Walmart (WMT) and daily-used consumer essential giant Procter & Gamble (PG) serve as two good examples of this. This strategy can best be used in what may possibly be a mid- to later-stage bull market when investors may fear a downturn but still believe there's a possibility for growth.
Buy a safe bond fund. Access to debt instruments tends to be ideal when the world begins to look for safety from the stock market. The consistency of a fixed yield in holdings perceived to be "safe" is attractive to a world faced with instability. The iShares Barclays 20+ Year Treasury Bond ETF (TLT) and the Vanguard Intermediate-Term Bond ETF (BIV) serve as two examples to consider. TLT invests in US treasury bonds and currently yields a 3.4% yield while the BIV invests in US treasury notes and currently yields a 3.5% distribution. In the case of TLT, we see that historically the fund traded higher when the stock market felt weakness. Investing in a safe bond fund can serve as a diversifying maneuver for a portfolio at any time, but adding them into your holdings may be most ideal when the growth opportunity found in equities appears to be waning.
Buy a hedging position. Funds that specialize in shorting can serve as short-term relief for investors who enjoy timing the market. The advantage allows for increasing gains throughout a general downturn in the market which can offset the losses incurred by an investor's other bullish positions. The ProShares Short S&P500 (NYSEARCA:SH) is one such fund that specializes in shorting the market. As inverse funds will tend to have their value deteriorate over time, investing in such positions are ideal in late-stage bull markets and beginning bear markets. However, there are alternatives. The Active Bear ETF (NYSEARCA:HDGE) trades as an investment company that is actively managed and therefore does not face the value deterioration problems normally associated with inverse funds.
Buy a volatility play. One of the unique characteristics of a bear market will tend to be sharp rises in volatility across the market as uncertainty builds. Most often tracked by the Volatility S&P 500 (VIX), derived funds such as the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the iPath S&P 500 VIX Mid-term Futures ETN (VXZ) serve as popular investments one might consider. By taking long positions on funds that specialize in volatility, investors could capitalize upon the spike thereby offsetting some of the losses incurred in bullish holding positions. Investors in these funds should use extreme caution due to the inherent roll-over nature from positions in the front month to those found further out in time. The value lost in this transition is the effect called contango, and it near dictates that these volatility plays will continue to have their value deteriorate over time. Investing in a volatility play is most ideal for investors with a very short investment time frame and taken at the start of a bear market.
Disclosure: I am long HDGE.