How to Stay on Your Feet in a Bear Market

You just took a punch. Now, make a comeback

What we took as articles of faith during the bull market are being reexamined in the harsh light of the worst bear market in decades. Is buying and holding stocks for the long term really the only strategy? Will stocks always beat bonds over time? Will diversification--and index funds, the ultimate diversifiers--protect your money from disasters such as Enron and WorldCom? By and large, the old rules are still good. The problem, in retrospect, was that we applied them as though they were immutable laws of nature rather than man-made guideposts to help us down the road to retirement, education for our children, or an inheritance for the grandkids.

In such a heated environment, stick to the principles of investing. "Decision-making under circumstances of uncertainty is a frightening process," says Peter L. Bernstein, who heads a New York advisory firm for institutional investors that bears his name. "You stand a better chance of doing well if you have a plan."

Still, it's necessary to scrutinize how you apply those old rules in a much-changed world. Take, for instance, the assumptions about expected returns on stocks. During the bull market, investors and financial advisers used a guideline of 10% annually--and thought themselves prudent in doing so because they were making multiples of that every year. What people haven't always understood is that there can be long stretches when stocks decline or stagnate. The Dow Jones industrial average, for instance, briefly edged above 1,000 in 1972 and again in 1976, 1980, and 1981. It wasn't until the bull market began in 1982, however, that the Dow sprinted past 1,000 for good, according to Ned Davis Research.

One way to navigate a low-return market is to invest in dividend-paying stocks. A 2% payout per year was laughable a few years back when many stocks were making that in a day. Now, a company that pays a 2% dividend looks pretty good as long as the share price doesn't decline. "In an environment where everything is being questioned, dividend checks are not," says Steve Galbraith, equity strategist at Morgan Stanley.

Investors need to keep a closer eye on the calendar. During the bull market, many parents kept college funds invested in stocks until the day they mailed their tuition checks. That strategy has backfired for families facing college-tuition bills now. For those with students with at least three to four years to go until they enter college, there is still time to hone exit strategies or come up with a completely new approach.

Many investors thought that they had adequately diversified their stock portfolios by investing in a Standard & Poor's 500-stock index fund. But since March, 2000, the S&P has lost 41%. Those who took a broader view and diversified beyond the S&P--into real estate investment trusts and small-cap value--have fared better. And if diversification doesn't lower risk enough, put options can, for a price, put a floor under your investments.

During the 1990s, we knew stocks were risky but never felt the pain. Sell-offs were short-lived. But now we're in the third and most frightening year yet of a bear market, and we're badly bruised. Here are some strategies that can help heal your wounds and show you a few moves so you won't get pummeled again.

By Susan Scherreik

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