The simplest answer to this question is straightforward: Taking you money out of the market is the worst possible thing you can do. But there are a few steps you can take to reduce your market risk, especially toward the end of a long bull market run.
Why You May Be Thinking of Pulling Out of the Market
As of December, 2017, we're in the second-longest lasting bull market in over 100 hundred years. While no one can predict when a bull market will end, what you can say with confidence is that eventually this winning bull market, like all previous bull markets, will come to an end and that a declining bear market will follow. The stock market is profoundly cyclical, with bull markets averaging about six years in length and bear markets averaging about a year and a half.
The italics in the previous sentence are there for a reason: Pundits widely disagree about the exact lengths of these two halves of the market cycle – the lengths given here are just rough averages of opinion. But what is undeniably true is that when a bull market is over eight years old, it's getting long in the tooth. Pulling out before the good times end by selling your stocks and getting into cash may seem like a wise move. The reality is that it's probably the worst thing you could possibly do.
Why Pulling Out of the Market's a Mistake
To better understand why you should stay invested even when bad times begin to roll, consider the cyclical aspect of the stock market. Not only do bull markets last about five times longer than bear markets, every bull-bear market pair in the history of Wall Street has tipped strongly in favor of overall gains - for over a hundred years, when you stay invested through the entire cycle, you gain more than you lose.
Not only that, but if you hang in there during a bear market, your account will be back to where it was at the height of the previous bull market in just over three years.
Now, it's true this kind of thinking only works when you're in it the for the long run. If you're a stock trader instead of a stock investor, these generalities may not apply. Which, incidentally, is one of the reasons you don't want to be a trader and you do want to be a long-term investor. An extensively documented economic paper on the subject of trading on Wall Street concluding that the more often stock trades occurred in accounts, the worse the returns.
"But Wouldn't I Be Better Off Getting Out Once We're in a Bear Market?"
Despite the clear advantages of buying and holding through market cycles, you will hear tempting tales about someone who was clever enough to get out just before a crash and who then bought back in at the very beginning of the following bull market. Admittedly, this sounds like a great idea for maximizing market profits. But there are two problems with this way of thinking:
1. When Does a Bear Market Begin?
The first problem is that no one can be sure when a bull market's really over and the following bear market begins. Of the eight bull markets since 1926, all but one of them had at least one major market correction, some of them as many as six – a market correction being a downward move of at least 10 percent. If you get out when the market starts to fall, you may be getting out during one of these corrections – in other words, way too soon.
2. When Does a Bull Market Begin?
The other problem with bailing out of the market to avoid a loss is that once you're out, when do you get back in again? Just as bull markets have major corrections of 10 percent or more, so bear markets have brief blips upward before they reverse and continue to fall. Once you're out, the chances are very good that you'll get back in during what turns out be only a brief blip upward, You'll then be invested in the bear market you tried to avoid. Alternatively, you'll wait too long to get back in and miss substantial gains.
An influential article by two University of California economists observed that most retail investors substantially underperform the market. One of the main reasons, they found, was investors' attempts to escape bear markets by going to cash and then missing out on the substantial gains to be made at the beginning of the following bull market. A study by ValueScope Analytics, unfortunately not available to the public, concluded that the average gain in the first two years of a bull market was 64 percent! They also noted that 16 percent of these gains occurred in the first two months of a bull market, leading these analysts to conclude that timing the market was "rather difficult." I think this was economists being funny – what they meant was: it's impossible!
Tales of the guy who knew just when to get out and when to get back in may or may not be fact-based. In a statistical universe, its almost inevitable that someone will time a market bail-out just right, so some of these tales are likely true. As the saying goes, even a broken clock is right twice a day. But making money by market timing is luck, not wisdom. Most investors who try to time their exits and entrances to the market, will guess wrong.
What to Do Instead
Here's a short list of things to do that will protect you from substantial losses in a bear market – you'll still lose money, but you'll lose less and have the satisfaction of being in the market and making money again when the next bull market begins:
1. Cut Back a Bit On Your Biggest Winners
Certain kinds of stocks tend to gain the most in bull markets. During the bull market that began in 2010, the biggest winners were in technology, banking, health care and e-commerce. Google, Amazon and Apple have been particularly big winners. These giant companies are probably going to continue to dominate their enterprise areas, so getting out of them in anticipation of the coming end of the current bull market wouldn't be a good idea. On the other hand, stocks that win big are by definition volatile. Volatility is a two-way street. In a bull market, they'll probably underperform boring stocks.
One conservative strategy so far as these volatile big winners are concerned, is simply to cut back on them a bit as the bull market ages. How much is up to you, but probably by at least 10 percent of your current holdings, and probably by not more than 30 percent.
One strategy related to this is to buy back the same dollar amounts of these stocks once The National Bureau of Economic Research declares that the recession has ended. The Bureau is rather conservative about this and almost always make the call a few months after the market turn. On the other hand, they've never been wrong, so you won't be buying back into a bear market in response to a brief upward blip. In another words, it's a safe strategy that doesn't try to time the turn, but instead simply follows the trend.
2. Sell Companies That Have a Lot of Debt
On your online broker's research page you'll be able to access the stats for each of your stocks. One of the things to look for is the Current Ratio, which is the ratio of current assets to current liabilities. Another useful ratio, sometimes called "the Quick Ratio," is the ratio of the company's cash plus accounts receivable to current liabilities. Both of these ratios will tell you a lot about how well a company is likely to do in a severe downturn. A well-run company will likely have both current and quick ratios of at least 1.0. If both look a lot higher than their competitors, they're going to be at a particular disadvantage in a recession, when banks tighten up their lending. Getting out of these stocks late in a bull market's a good idea. So is diversification in a bear market, so instead of replacing these stocks with others, consider buying mutual funds instead.
3. Get Out of Growth Funds and into Value Funds
If you're not sure which of your mutual funds are growth funds and which are value funds, go to the research section of your online broker and pull up each fund. The managers of these funds generally design them to be one or the other and will state the purpose of the fund in the prospectus summary on the fund's home page.
Growth Funds are often described as being designed for "capital appreciation." In other words, to "outperform the market," But, again, stocks that outperform the market in a bull market environment tend to have "high betas" – to be volatile. Consequently, they tend to underperform in bear markets. In bear markets on the other hand, Value funds generally outperform.
Value fund managers look for stocks that are the ugly ducklings of the market – they're not losers, but they're investors unexciting and often overlooked. As a consequence, when subjected to analysis, they are often selling for less than they're really worth.
While not all investors are aware of this, value funds with their relatively homely stock portfolios outperform their flashy growth fund cousins most of the time. The only time growth funds outperform value funds is in the first two or three years of a bull market.
Therefore, as a bull market ages, and usually right around the time that a lot of television pundits are declaring that the present bull market has a long time yet to run, sell your growth funds and buy value funds with the money. In the following bear market, you will probably still lose money (although in a couple of bear markets, value funds actually gained overall), but you'll likely lose considerably less.
When the bear market has ended is a good time to rebalance your portfolio and increase the ratio of growth funds to value funds. The advantage of growth funds to value funds at the beginning of a bull market generally last for a couple of years.