To understand how to balance your portfolio in bear markets we first must define what they are. A bear market is defined as a decline of 20% in all three major stock market averages (the Dow Industrials, S&P 500 and NASDAQ Composite). This is determined from the highest close to the lowest close. Since 1926 the average bear market has lasted an average of 1.3 years. These types of markets do not drop in a straight line. What you see is 10 to 20% declines followed by strong rallies. These kinds of markets are also accompanied by tremendous amounts of fear. In this article we will examine ways to protect and balance out your portfolio during bear markets.

Dividend Stocks

One way to balance out your portfolio during bear markets is through dividend stocks. To understand how they work and what are good dividend stocks we must first define what is a dividend stock . A dividend stock is a stock where a taxable payment is declared by a company’s board of directors and is given to the shareholders from the current or retained earnings that occur usually on quarterly basis. They are mainly in cash but can also come in the form of stock as well. Dividends are generally used by stable companies to provide an incentive for investors to own their stock. Most companies that offer them have matured in growth where they no longer need to invest their profits back into the company and instead choose to pay these profits to shareholders in the form of a dividend.

What to look for

Generally with dividend stocks there are certain characteristics that you want to look for. A key is to find those companies that have a history of paying a consistent, uninterrupted dividend over a period of many years. As a general rule companies that have a continued history of paying these dividends are committed to continuing to that policy. Second, each company should have a consistent history of either paying it’s dividend or raising it going back at least 20 years. This is a sign of financial strength in that it requires cash to consistently pay that dividend over that period of time. Also a rising dividend usually means that these are companies who have shown promising growth in the past and can be trusted to deliver solid earnings in the future.

How they can benefit you

Historically, studies have shown that the returns that you receive from both consistent dividend returns and an increasing stock prices out perform all the major stock market averages over time. Second, the consistent dividends can provide you with income that you can receive while you own the stock. Third, companies that pay dividends consistently over long periods of time usually are more stable during bear markets than other stocks.

Preferred Stocks
A second way to balance out your portfolio during bear markets is through preferred stocks. A preferred stock pays a specific dividend before any are paid to common stockholders. In the event of liquidation they represent partial ownership in the company and receive priority over common stockholders but after bondholders. They also do not enjoy the same voting rights as common stockholders. The dividend that they pay is fixed and does not change. The big advantage to owning them is for the greater claim on the company’s assets and the owners of preferred stocks are always paid their dividends first.

How they work

There are four types of preferred stocks. They are: cumulative, non cumulative, participating and convertible. Cumulative is when the dividends build up if the company does not make the dividend payments when it is suppose to. Most preferred stock comes in this form. Non cumulative is when the dividends that have not been paid do not build up. Participating preferred is when you receive your regular dividend and then you participate with the common stockholders in extra dividends. Convertible can be exchanged for a particular type of another security usually common stock.

How they can benefit you

Since 1900 preferred stocks have had an average yearly return of 7.4 %, while corporate bonds have averaged 6.4% and common stocks have averaged 10%. The way that they can benefit you is that you will receive a consistent dividend from them. Second, they can allow you to see an appreciation in value over time. Third, if the company goes into liquidation you have a higher claim to those assets.

Fixed Income

There are two different types of fixed income investments. Both can be used as another way to provide balance to your portfolio during bear markets.

Certificates of Deposit

A certificate of deposit (CD) is a savings certificate that has a stated maturity date, interest rate, and can be issued in any amount. They are usually issued by commercial banks and are FDIC insured. Generally, if you withdraw funds prior to the maturity date there is usually a penalty that you have to pay. These investment are not tied to the stock market and can be used to provide your overall portfolio with stability. They are generally a risk averse investment and they offer a higher rate of return compared to money markets.

Bonds

A bond is a fixed interest asset that is issued by corporations, governments and other large organizations. They pay the principal and the interest until a specified date. When an investor purchase the bond they become a creditor but do not have any type of ownership rights. What this means is that bond investors have claim to the organizations income and assets should they have financial problems. There are several different types of bonds. The safest is U.S. Treasury Bonds since the odds of non payment is almost zero. Then there are municipal and state bonds which are issued by local or state governments. Followed by corporate bonds that are issued by corporations. Generally a riskier bond offers a higher payout to accommodate investors for that risk. By and large, some local and state bonds are not subject to federal income tax and in some cases are not subject to local or state taxes. Bonds are a good investment for those who want to limit the volatility of the stock market and can be used to provide income, balance or safety.

How you can structure them to provide the most income

A good way to structure your portfolio is through a process known as laddering. This is where you spread out the different time frames (maturities) and interest rates to ensure that your overall portfolio has an average maturity and interest rate. The way you do this by putting a certain amount in short term maturities (say one year), then some in medium term maturities (say three to five years) and some in longer term maturities (say ten years). When the short term ones become due you put the money into longer term maturities. What this does is ensure that you have a consistent interest rate coming in so that if rates start to rise you can reinvest the ones that are coming due at a higher interest rate. If interest rates are falling you have managed to lock in an overall higher interest rate. That way you don’t have to worry about how you can keep the interest you are receiving at a consistent amount.

Conclusion

There are many ways to balance your portfolio during bear markets. The above mentioned ways can deliver income, dividends, safety, growth and an overall balance. To decide how much of each you want to have in your portfolio depends on factors such as risk tolerance and the amount of income you are looking to generate. By doing this properly you will generate a consistent income and take out the up or down swings that so many investors go through during bear markets.

Chris Seabury has over 12 years experience following and writing about financial markets. Over the years he has educated and helped a great deal of investors get their portfolio in order. He currently has a financial blog that is dedicated to helping investors understand how the markets work and what they can do to benefit from them. http://davidsonreports.blogspot.com

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