Should You Be Afraid When Stocks Tumble Into Bear Market Turf?

If you’ve been following stock market news in 2022, you’ve probably heard that we’re nearing bear market territory. A bear market is a prolonged drop in the stock market of 20% or more.

Bear markets may seem terrifying, particularly if you monitor your retirement accounts and other investments daily. But bear markets tend to be short, and they’re actually quite common. If you take a few steps to prepare, those falling stock prices can actually present opportunities to you as an investor.

Keep reading to learn how bear markets work, what causes them, and how to prepare if you’re worried a bear market is ahead.

What Is a Bear Market?

A bear market is a sustained decline of at least 20% in stock prices or other securities prices. A stock market correction is similar, but less severe. When stock prices drop by more than 10% but less than 20%, it’s considered a stock market correction. Commonly, these thresholds are calculated using a major stock index as a benchmark, like the S&P 500 index, the Nasdaq Composite index or the Dow Jones Industrial Average.

As of this writing in mid-June 2022, the S&P 500 index — which represents about 80% of the U.S. overall stock market — was right around bear market turf, having fallen about 20% from its all-time high in early January. But the tech-heavy Nasdaq Composite Index has been in bear market territory since March, when its value tumbled 20% below its November 2021 peak.

When stocks tumble below 20% of their record highs, it’s typically big news. But it’s important to remember that there’s nothing particularly significant about that number. So there’s no reason to panic just because we officially crossed into a bear market.

The opposite of a bear market is a bull market. A bull market is a sustained period of rising stock prices and high investor confidence. A new bull market begins when stock prices rise by 20% or more from their recent lows.

Bull and bear markets are both normal parts of the market cycle. In fact, both are crucial to your long-term success as an investor. A bull market offers the largest potential gains because that’s when stock prices rise. But if you only invested during bull markets, you’d consistently pay top dollar for your investments. Bear markets allow you to invest when prices are low and sell at higher prices when the market recovers.

What Causes a Bear Market?

A bear market is caused by growing investor pessimism. Investors tend to sell off stocks when they’re nervous about the direction of the economy, so they sell off stocks, causing stock prices to drop. Bear markets often begin before an economic recession or downturn. Some common bear market triggers include:

Market Bubbles Bursting

Sometimes a certain segment of the market becomes overheated and prices then crash dramatically. For example, the bear markets that occurred in the early 2000s were triggered by the dot-com bubble bursting. After the housing bubble began to burst in 2007, eventually resulting in the 2008 financial crisis, a 17-month bear market.

Rising Interest Rates

Rising interest rates make it more expensive to borrow money, which often reduces corporate profits. That’s why stock prices generally drop in anticipation of the Fed raising rates, with a few exceptions — like the banking sector. During times of high inflation, the Fed hikes interest rates with the goal of cooling off spending.

When interest rates rise, investors tend to consider alternatives to investing in stocks, like bonds. Higher interest rates make investing in bonds more profitable, plus bonds have historically been a safer investment than stocks. Reduced demand for stocks causes prices to plummet even further.

High Inflation

High inflation triggers interest rate hikes, but that’s not the only reason Wall Street doesn’t like it when inflation gets out of hand. Higher costs don’t just eat away at your budget. They also reduce corporate profits because companies have to pay more for materials, wages and financing.

Companies in high-growth sectors, like technology, are hit especially hard by inflation. One reason is that many of these companies aren’t yet profitable, so they have high levels of debt. That means higher interest rates are especially hard on their bottom line. Another contributing factor: When investors’ confidence is low, they often move their money from high-risk, high-reward investments like tech stocks to less risky companies with lower growth potential.

Uncertainty

If there’s anything the stock market despises, it’s uncertainty. Geopolitical conflict, shortages, pandemics, high oil prices and rising unemployment are among the many factors that can cause investor sentiment to sour.

Source: Hartford Funds

How Long Do Bear Markets Last?

The good news is that bear markets tend to be much shorter than bull markets. According to Hartford Funds, the average bear market from 1928 to 2021 was 289 days, or roughly 9.6 months. But the average bull market was 991 days, which is about 2.7 years.

In the same period, there have been 26 bear markets and 27 bull markets. But bear markets are becoming less frequent. Twelve of those bear markets occurred between 1928 and 1945, or once every 1.4 years. But since World War II, just 14 bear markets have occurred, which works out to one every 5.4 years.

The shortest bear market in history began on Feb. 19, 2020, and lasted just 33 days. The trigger, of course, was the rapid surge of COVID-19 cases that led to lockdowns and widespread unemployment throughout the globe. Through March 23, the S&P 500 index dropped by 34%.

Since bear markets tend to be relatively short, it’s not surprising that the losses are smaller compared to the gains earned during bull markets. The average bear market produces losses of 36%, while the average bull market resulted in a 114% gain.

All investing involves some risk, and past performance doesn’t guarantee future results. But historically, withdrawing from the market after a crash has been much riskier than staying invested through a bear market.

In the 20 years between Jan. 1, 2002 and Dec. 31, 2021, seven of the 10 best days of the market happened within two weeks of the worst days, according to J.P. Morgan Chase. An investor who remained fully invested in an S&P 500 index fund would have averaged annual returns of 9.62%. Missing the 10 best days of the market would reduce your average returns to 5.33%.

On a $10,000 investment, that translates to a final value of $61,685 for someone who stayed fully invested at the end of 20 years. But for the investor who missed the market’s 10 best days? They’d have just $28,260.

How to Invest in a Bear Market

When stocks near bear market territory, it’s natural to panic. But it’s important to avoid making financial decisions based on emotion. If you’re worried about a bear market, follow this investment advice:

• Don’t sell. Selling when prices fall is the worst move you can make as an investor. Stocks have always recovered from bear markets over time. But if you sell investments while they’re down, you’ll miss out on the recovery and possibly lose money.

• Build your emergency fund. Having an emergency fund that can carry you for three to six months is a smart way to protect yourself from a bear market. Should you lose your job or face an unexpected expense, you’ll have a source of cash to draw from without having to sell investments before they’ve recovered.

• Practice dollar-cost averaging. Most investors will benefit from a strategy called dollar-cost averaging. You invest a designated amount at certain intervals, like every week or month, regardless of the stock market’s performance. Doing so lets you lock in lower prices during market downturns so you can make even bigger gains when the market recovers.
• Invest in a diversified portfolio. You don’t want to put all your money in a few individual stocks or stock market sector. Investing in a diversified portfolio protects you in case any one company or segment of the economy performs poorly. The easiest way to diversify is by investing in a mutual fund or exchange-traded fund (ETF) that tracks a large segment of the stock market. For example, when you invest in an S&P 500 index fund, you automatically invest in 500 of the largest companies in the U.S.
• Use a bear market as an opportunity. If you have a solid emergency fund, a moderate to high risk tolerance, and can afford to invest extra, a bear market can be a great time to invest extra money. Just remember that this works best as a long-term investment strategy. It’s impossible to predict the bottom of a bear market, so prices could dip even more before they rebound.

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Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Click here to subscribe to the Dear Penny newsletter.