APRIL 2003

Lesson 202

Bull and Bear Markets

Surviving a Bear Market

Diversification

Bull and Bear Markets

Who is in charge of the market these days? The growling bear or the charging bull?

Whatever the answer, it's important to know exactly what a bear and a bull market are, and how to keep your head above water in a bear market. In a bull market, stock prices are generally rising; in a bear market, stock prices are generally falling.

All markets follow cycles, where bull markets are followed by bear markets, and bear markets are followed by bull markets. In the late 1990s, investors enjoyed an unprecedented bull market. In fact, the bull market continued for so long that some analysts and investors predicted that the market cycle was dead. The market's downturn in spring of 2000 showed that wasn't so.

A bear market is officially defined as a 20 percent drop from a market high. While the stock market may seem like a monolith, there are actually a number of different exchanges and indexes, and different parts of the market can be in a bear market at different times.

For example, if the Dow Jones Industrial Average has fallen 23 percent, while the S&P 500 has fallen 18 percent, the Dow will be in an official bear market, while the S&P 500 will still be in a bull market.

A steep market decline can thrust market indexes into a bear market over night, while market rallies can quickly bring the indexes back into bull territory. What is frustrating about many bear markets is that they aren't sudden drops, but slow, grinding declines over a period of months or even years.

The market crash of 1929 was a sudden drop that was followed by a slow, remorseless decline that lasted many years. The bear market of 1973-74 left the S&P 500 down more than 50 percent in a nearly two-year period, and it didn't recover its pre-bear market value for almost 10 years.

Surviving a Bear Market

How do you survive a bear market with your portfolio intact? If you're invested in stocks directly or through mutual funds, it's very unlikely that your portfolio will remain totally unscathed.

If you experience a bear market, remember that this too shall end. Just as all bull markets inevitably turn into bear markets, bear markets inevitably turn into bull markets.

However, no one can say when, which is why you should stay invested. In fact, if you regularly add to your mutual fund or stock investments, bear markets can be a good time to dollar-cost average. When you dollar cost average, you invest a consistent sum of money at a regular interval.

For example, say you are invested in the ABC Growth Fund, and you purchase $200 worth of shares each month. During the bull market, say the net asset value of shares fluctuated between $20 and $25 a share. Your $200 would buy you 10 shares of the fund at the low point of $20 and 8 shares at the high point of $25 a share.

In a bear market, say the net asset value of your fund drops to between $10 to $15 a share. In this case, your $200 would buy you 20 shares at the low point and 13.3 shares at the high point. You can see that you are purchasing more shares when the fund's net asset value is low, and fewer shares when the fund's net asset value is high.

Diversification

One way to minimize loss in the value of your portfolio during a bear market is to have a diversified portfolio. By investing in different types of stock funds, you can protect your portfolio from the damage inflicted by a severe bear market in a particular market sector.

Mutual fund investors can diversify by owning shares in large, medium and small-cap stock funds. Typically, different sectors of the market are in favor at different times, so while small and mid-cap companies are performing very well, large-caps are faltering. During a period of many years, the rise and fall of different market sectors usually offset each other, leading to an overall solid total return in your mutual fund portfolio.