It's been 9 years since the last economic expansion and bear market in stocks. Historically, this has been one of the longest economic expansions and bull markets in history. (This applies to the global economy and stock markets. Developed economies and stock markets move in sync).
So what if a market storm occurs again? What if the economy turns down? How do we protect our portfolio when bad things happen?
Buy long term government bonds instead of short term government bonds
Bonds should be a part of every long term investor's well balanced portfolio. UK government bonds have one of the highest ratings, meaning that there's an extremely low risk of default. So when the inevitable bear market in stocks comes along, bond market investors will outperform. By holding bonds, you at least ensure that one part of your portfolio will be safe when the next recession and bear market comes along.
But the question is: what government bonds should you buy? Short term bonds or long term bonds?
Inflation tends to rise towards the end of economic expansion cycles. This means that the ECB and Bank of England will have to start raising interest rates soon. When interest rates rise, current bond holders essentially lose money. For example, let's assume you own a bond that yields 2%. If interest rates rise to 3%, current bond holders are missing out on an additional 1% in yield. This is an opportunity cost.
Hence it isn't a good idea to own short term bonds when inflation is rising. The longer you wait, the higher the bond yield will be. Short term interest rates are the most sensitive to the central bank's decision. When the central bank raises interest rates, short term rates rise the most.
Long term rates rise more slowly than short term interest rates when the central bank raises rates. This means that investors in long term bonds won't be too adversely impacted when central banks hike rates. (This is called the yield curve inversion).
That's why investors should own some long term bonds in their portfolio.
Dividend stocks are better than growth stocks
Investors should switch from owning growth stocks to dividend stocks.
Growth stocks tend to outperform in a bull market. Dividend stocks tend to outperform during a bear market. Here's why.
- Growth stocks tend to be “story” stocks like FANG – Facebook, Amazon, Netflix, and Google.
- Growth stocks tend to become EXTREMELY overvalued (too expensive) during bull markets. But because it's a bull market and the majority of investors are still buying stocks, these growth stocks tend to continue to outperform the broad stock market.
- Dividend stocks tend to be the opposite. Dividend stocks are often “boring” companies that not many investors have heard of. Dividend companies tend to be low growth companies: afterall, the only reason why most companies issue high dividends is because they can't put that cashflow to better use in their own business. (Growth stocks reinvest most of their money into their business).
- Growth stocks usually aren't as overvalued during a bull market. So when the inevitable bear market arrives and the whole stock market falls, dividend stocks will fall less because they weren't that overvalued in the first place.
In addition, dividend stock owners will at least receive the dividend during bear markets. These dividends will offset some of the capital losses. For example, let's assume that Dividend Stock XYZ falls -30% during a bear market. If the company throws off 4% in dividends over 2 years, the stock owner only lost -22%. He received a total of 8% in dividends.
Raise some cash
The secret to long term investing is that you don't always have to be fully invested! If there are few good opportunities because assets are generally too expensive, then there is no shame in holding onto cash and waiting until the next major dip to buy.
This is the mistake that many long term investors make. They think that they always have to be fully invested. Think about it this way. If you're a business owner, do you try every single idea that comes to your mind? Probably not! You'll focus on trying the ideas you think are most likely to succeed. You won't put much effort into ideas that have a 1-in-100 chance of succeeding.
Remember, you don't always have to swing the bat. Be patient, and wait for better opportunities if there are few good opportunities right now.
Hi, I'm Troy! I'm a trader who focuses on the U.S. stock market. I share my investment and financial thoughts at Bull Market. I use quantitative models to know exactly how well my investment and trading strategies perform.