How to Manage Risk While Building Long-Term Positions in a Bear Market

When the market is ugly, there is always one phenomenon that occurs – investors rushing to buy long-term investments because they believe that they are now great values. It doesn’t much matter what the market environment might be, if there is a big drop, then the long-term investors deem it an opportunity to buy.

The justification for this behavior is usually something like: “In five years, this great stock is sure to be much higher, and since no one can time the market, I’ll just jump in now.” Dip-buyers have tended to do very well in the big uptrend since 2008-9, so that thinking has been reinforced, but in a bear market it requires some modification.

Building long-term investments in a bear market is a great strategy, but with some modification and recognition of the risk involved, it can be greatly enhanced.

There are two big risks when you buy a downtrending stock in a bad market. The first is that you buy the wrong stock, and it never recovers as hoped. The stocks that lead in the future are likely to be different than those that led in the past. Some of the great stocks in the bubble in 2000 never rebounded. A good example is Cisco Systems (CSCO) which was a star in 2000, but 222 years later it has never fully recovered its losses. Those that bought this stock as it fell have buried themselves in a subpar investment.

The second issue is timing. There is no way to know how long this bear market will last or how low it will go. What seems like a great value today may turn out to be even a better bargain months from now.

Entry points matter even if you are a long-term investor. If you can improve your average cost by even a small amount, it will have a tremendous impact in the long run due to compounding over many years. A 10% improvement in your cost basis could double your return over the course of five years if you pick the right stock.

How do you handle these two big risks?

1. Build a Shopping List

The first step is to identify those stocks that you feel will be leaders when market conditions shift. It is important to recognize that in a bear market, price movement tends to be correlated and index-driven. Many great stocks are sold without regard of their fundamental values because they are part of an index or ETF that is being sold.

We will discuss stock-picking in much greater depth in future articles, but the key is to find some new ideas and not just hope that the stocks that worked in the past might work again. There will be new leaders in emerging bull markets, and those are the names where you want to invest your capital.

2. Stalk Your Targets

Once you have a shopping list, don’t just plunge in. It might make sense to take a small tracking position that will keep you attentive, but you want to learn the personality of the stock and how it a reaction to the overall market environment. You should gain a sense of whether it has a fundamental value that is being overlooked due to market conditions.

3. Watch the Chart

The biggest mistake that most people make in a bear market is being into the teeth of a decline. The emotional reaction is that the lower a stock goes then, the better value it must be. That may work with consumer goods, but it is illogical thinking when it comes to stocks. The goal with stocks is to buy them when they have the best chance of sustained upside. You do not want to tie your money up in a stock that is a great value but then never goes up. The market has to recognize the greatness of a stock for it to move, and the best clue that that is occurring is when there is relative strength.

4. Use Support Levels

One of the benefits of buying a stock after it has shown some strength is that the prior lows become very clear support levels. If those support levels fail, then you may need to reposition and question your view of whether this is the right time to be aggressive at expanding a position.

5. Average Up and Not Down

The biggest losses for most investors occur when they continue to add to a position as it keeps on dropping. The position becomes uncomfortably large, and then they panic sell when it refuses to bounce. It may have just been a bad stock pick. Positive price action can help you confirm that you are on the right track. If the market is recognizing that a stock is a good one, then that is the time to add to your position. A good stock will continue much higher, and your risk is reduced when you are buying strength rather than weakness.

6. Trade Around a Core

One way to reduce risk as you are building a long-term position is to trade around a core position. Use volatility to buy and sell partial positions but keep a core position as long as your long-term view of the stock remains the same. The shorter-term trading allows for greater flexibility, and if done right, it can reduce your cost basis substantially.

We are currently dealing with an ugly bear market, but the good news is that this sort of action leads to the best opportunities. Don’t just buy stocks because they are lower. Use a systematic approach, and you have the opportunity to profit greatly.