Outwitting the Bear

by Paul Merriman

Ten ways to crash-proof your investments

Everybody's a genius in a bull market, the old saying goes. But a bear market creates fear, uncertainty and costly mistakes.

The conventional definition of a bear market is a decline in stock prices of 20% or more, lasting at least two months. As markets have become more diverse, experts have developed other measures, too. Whether or not Wall Street is in a bear market, every investor can have his or her personal bear too. Your personal bear market is an unbearable price fall in the value of your nest egg.

You can experience two types of bear markets, temporary and permanent. Markets tend to go up and down and then back up. In a temporary bear market, you lose 20% or more but eventually recover. In a permanent bear market, you lose 20% or more and you never get it back. All the historical evidence I've seen indicates that a properly diversified portfolio has never suffered a permanent bear market. Unfortunately, some common investor behaviors can easily turn temporary losses into permanent ones.

Here are 10 ways to avoid permanent losses and crash-proof your portfolio:

1. Diversify among many stocks

If all your money is in Washington Mutual (WM) shares, you're hurting because of the sub-prime mortgage mess. Microsoft (MSFT) shares are still worth less than half their value at the start of 2000. If you own a diversified portfolio, you're unlikely to suffer that kind of pain. Own thousands of stocks via mutual funds.

2. Diversify across many sectors

Financial services and homebuilders are doing poorly now. Yet energy, natural resources and export-intensive industries that benefit from a weak dollar are holding up better. Own the Standard & Poor's 500 Index (SPX), and you're invested in energy, industrials, information technology, consumer products, healthcare, telecommunications and much more.

3. Spread your portfolio among different asset classes

Be sure to look beyond the S&P 500 to achieve this goal. Examples include value, small-cap, large-cap and growth. Every asset class we recommend has a long-term history of success. They have made money despite plenty of temporary losses.

4. Spread your investments geographically

I'm not talking about country funds. The answer is not to put some of your money in Brazil, a little in India and some more in Germany. The answer is to diversify throughout the world. International index funds are the best way to do this.

5. Don't forget fixed income

Even with all this diversification, you still need some fixed-income investments such as bond funds. Don't expose your entire portfolio to the stock market. Fixed-income funds can be a great stabilizer. Just how much fixed income you need depends on your circumstances, and figuring this out is worth spending some time with a good financial advisor. Further reading: "Fine tuning your asset allocation."

6. Consider a mechanical defensive strategy to limit losses

Active risk management isn't for everyone, but it is possible to follow systems that let you invest in an asset when its price is rising and switch to cash when its price is falling, without your having to make any forecasts. Every day that your money is in cash is a day you're not exposed to a possible bear market. Don't do this without a firm discipline. You're asking for big trouble if you base your moves on your emotions or your own judgments about the market.

7. Avoid paying unnecessary expenses

If you neglect this, you can lose a lot of money and have no way to gain it back. In fact, you can lose more than you invest in the first place. Here's an example from our investment workshop, "Live it Up Without Outliving Your Money:" A 25-year-old who invests $5,000 a year in equities and earns 12% will wind up with $3.8 million after 40 years. But if that same investor neglects to pay attention to expenses and lets the return fall to 10%, the account will be worth only $2.2 million in 40 years. The difference, $1.6 million, is eight times the total dollars that the investor saved for 40 years.

8. Avoid paying unnecessary taxes

In an actively managed fund, the fund manager decides when to sell and incur capital gains liability that will impact your tax bill. Choose funds in which the management pays attention to limiting your tax liability. Avoid funds that churn their portfolios, buying shares for short-term gains that can hurt you at tax time.

9. Don't panic

Selling an investment after it's taken a big hit can leave you with a permanent loss. If it rebounds, which it probably will, you won't be there to benefit.

10. You can't outwit the bear by avoiding all risk

One of the worst bears in the forest is inflation, and it can be especially painful for the most risk-averse investors. If you want to hang onto cash in an environment of 3% inflation, you are almost certain to lose purchasing power over the long run. Even staying exclusively in Treasuries or other fixed-income securities can't overcome the combination of taxes and inflation.

Crashes happen and so do those nasty bear markets. But every investor can limit the damage by following these guidelines. Be patient. And if you have trouble keeping track of all these things, a good professional advisor can help you.