How to Prepare Your Portfolio for a Bear Market

by Kent Thune | August 13, 2014 11:24 am

Smart portfolio management is all about risk management, not market timing. Therefore, preparing your portfolio for a new bear market doesn’t mean jumping from stocks to cash, where you will miss out on the gains that come at the end of a bull market.

In fact, the smartest tactical moves to make when the market appears to be heading in a new direction only involve a few adjustments to balance the objectives of maximizing return and minimizing risk.

Fine-Tuning the ‘Core & Satellite’ Portfolio for the Next Bear

Of course, there is no one-size-fits-all portfolio of funds but the smartest variety share the same basic makeup.

Whether knowing it or not, most investors build portfolios that have a core and satellite structure, which is just as it sounds — one core holding that represents the largest percentage of the portfolio and several other funds, the satellites, that each have smaller allocation percentages.

The core is usually a large-cap index fund that tracks the S&P 500 Index or Russell 3000 and the satellite fund types may include foreign stocks, emerging-markets stocks, small-cap stock, investment-grade bonds, money market funds and maybe a few sectors for added diversity.

The best bear market portfolio will have the same structure. All that’s necessary to prepare for tougher times ahead is to reduce or eliminate the riskier fund types and increase exposure to or add fund types with lower relative risk. There are also alternative and riskier strategies, such as buying bear market funds, but we won’t cover that here.

Invest in This, Not That

To put it simply, our strategy is to keep the best and get rid of the worst. As the bull market matures, it’s a good idea to lock in some gains and reduce market risk. The first step is to identify and remove exposure to the riskiest fund types. Let’s look at some examples of fund categories that are commonly among the worst performers during a bear market.

Here is average performance by fund category in 2008, the most recent year containing a full bear market (for stocks, compare with a return of -37.0% on the S&P 500 that year and for bonds, compare with a gain of 5.2% on the Barclays Aggregate Bond Index):

• Average Diversified Emerging Markets Fund: -54.4%
• Average Foreign Large Blend Fund: -43.9%
• Average Technology Sector Fund: -45.3%
• Average Energy Sector Fund: -51.1%
• Average Consumer Cyclical Fund: -39.8%
• Average High-Yield (Junk) Bond Fund: -26.4%
• Average Long-term Bond Fund: -3.7%

These funds all underperformed the averages, so our bear market portfolio will not include any of the above. We’ll use a simple combination of a large-cap stock index fund, a small-cap index fund, an aggregate bond index fund, three defensive stock ETFs (healthcare, consumer staples, and utilities) and one gold fund.

Now on to what we will keep or add. Check out an example of a bear market, core and satellite portfolio with a solid combination of ETFs that can maximize return and minimize risk:

The Bear Market Portfolio Guide

I like index funds and ETFs for almost any market environment, but another risk to eliminate in a bear market is what I call manager risk. Volatility and uncertainty call for a passive approach, which can help avoid security selection and timing mistakes that managers of actively-managed funds can make.

Because this bear market portfolio consists of only ETFs, the primary selection criteria includes a balance of low expense ratios, long-term track records, and relatively high assets under management.

Here’s the bear market portfolio, along with suggested allocation percentages (the core is listed first, followed by the satellites):

• 30% Large-cap Index: iShares Core S&P 500 Index (IVV[1]), 0.07% expense ratio
• 10% Small-cap Index: iShares Russell 2000 Index (IWM[2]), 0.2% expense ratio
• 5% Healthcare Sector: Healthcare Select Sector SPDR (XLV[3]), 0.16% expense ratio
• 5% Consumer Staples: Consumer Staples Select Sector SPDR (XLP[4]), 0.16% expense ratio
• 5% Utilities Sector: Utilities Select Sector SPDR (XLU[5]), 0.16% expense ratio
• 5% Gold Index: SPDR Gold Shares (GLD[6]), 0.4% expense ratio
• 40% Aggregate Bond: iShares Core US Aggregate Bond (AGG[7]), 0.08% expense ratio

You can use index mutual funds as alternatives if ETFs are not your preference. Also, this is a simple asset allocation of 60% stocks and 40% bonds (although gold can be considered an “alternative asset” type). Some investors may also prefer using money market funds as an alternative to some of the bond allocation. For example, you might try 60% stocks, 30% bonds and 10% cash. The best allocation for you may be either more conservative or more aggressive, depending upon your investment time horizon and risk tolerance.

In summary, these fund types that typically perform as well or better than the major market indices during a bear market. They are also all areas that can provide positive returns in the mature phase of a bull market. Therefore, we have achieved our goal of balancing return and risk during and just before a bear market.

As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.

Source URL: https://investorplace.com/2014/08/bear-market-portfolio/

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