How to invest when the stock market declines

Economists may disagree among themselves on the exact definition of a bear market. However, it is commonly accepted that when the market drops between 15%-25% from its previous high, it is falling. Today, if you can somehow pick the low point of a bear market, you can become a millionaire just by buying stocks.

Investors and traders always feel anxiety and stress when they see stock prices rise and fall. However, for skillful investors, bear markets are good news, as they can provide them with opportunities to improve their portfolio and set it up for better long-term wealth accumulation.

Below, we list the key things you need to know when the stock market is going down.

1. Create a watch list

What's the point of having cash reserves in the event of a stock market crash if you don't know what to buy? It's not a good idea to make hasty decisions on the spot. So, establish and maintain your stock watchlist. Start with a list of companies you've heard about or read articles about that you think are a good choice. You could write them down on paper, but it's best to list them online.

Follow the companies on your list by researching them. Try to understand how these companies generate their income, what their sustainable competitive advantages are, who their competition is, what their growth potential is and where they stand in terms of financial strength like cash and debt.

When the market crashes, you will know which stocks are on your list and be able to intelligently choose which ones are the most appealing, which would likely grow faster, thereby earning you the most. Regularly reviewing your list can help you notice when the price of a particular stock (but not the overall market) drops significantly and therefore gives you a potentially profitable buying opportunity.

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2. Profit from short selling

The problem with bear markets is that they are tough on good stocks, but ruthless on bad ones. When bad stocks fall, they can maintain the downward trajectory for a long time. However, this can give you the opportunity to generate profits as it continues to decline.

When a bad stock goes down, the trend is for a more intense pullback, as more and more investors become interested in it and find that the company's finances are shaky. Shareholders will bypass the stock and wreak havoc when it continues to plunge.

But remember that betting on a falling stock is very risky. If you get it wrong and the stock goes up, you expose yourself to unlimited losses. A better way to bet on a falling stock is to buy long-term put options. This gives you the chance to profit if you are correct that the stock will continue to fall.

3. Diversify to mitigate your risks

Many people don't realise that it is safer to own more investments than less. The diversification investment strategy has allowed countless investors to reap huge returns over the years. They achieve higher average returns while reducing risk, as all of their investments are unlikely to go down at the same time.

For example, if you invest all of your savings in a company that is very popular right now but it is involved in a scandal, you could lose all of your money. But if that stock only represents a small percentage of your total portfolio, the loss has a much smaller impact. To mitigate market risk, it is key that you create a mix of investments that adapts to market conditions in various ways.

For many traders, especially those who aren't pursuing a career in stock picking, buying individual stocks is not the best practice. This is very risky due to the volatility of stock prices and their tendency to fluctuate sharply. Trying your luck with one or two winning stocks is not a smart and strategic investment, but more like a game of chance.

The good news is that it's easy and affordable to build a diversified portfolio just by buying stocks in a low-cost mutual fund or ETF (exchange-traded fund). The funds create a mix of investments in stocks, bonds, assets and other securities and bundle them into convenient buyable packages, as they are made up of several underlying investments.

Diversification alone doesn't necessarily increase the return on your investments. It simply reduces your investment risk and gives you more security and control while keeping the flow of returns intact. If a fund's stock price drops, there is no need to worry because you own hundreds of other stocks that aren't going in the same direction. Some of them may even increase in value.

4. Decide what your "breaking point" is

Think of this as the point where a board snaps, only in this case it's a particular stock when the market is going down. You can claim to be a fearless investor, to the point that your tolerance level is far too high. But there are a large number of investors who fear falling prices.

If they find that their short-term losses are getting worse every day, they tend to give up on taking any more risks. That's where many of them freeze and do nothing. They don't analyse the situation wisely and don't take the opportunity to buy or sell. Yet some traders take the extreme opposite direction by taking drastic measures and unintentionally damaging their portfolios.

Frankly, unless you go through one or two bear market seasons, it's very difficult to see if you have a breaking point or where it is. To help you, we suggest the following exercise. Suppose you have a current investment portfolio of £500,000 and you tell yourself that if it drops below £300,000 you will be a financial wreck. This means that you can sustain a loss of around £200,000 - which is now your breaking point. In this case, a loss of 40% is tolerable (or £200,000) and you can overcome it. But if the drop is more than 40%, which is your breaking point, you will have to sell.

5. Concentrate on value stocks instead of "dream stocks"

Stock market crashes aren't always negative events, as they can be good buying opportunities for those who have prepared for such episodes. When you look at your watchlist, it shows you all the stocks you want to buy and you can see how low they've fallen. You can also find other great stocks by reading, watching or listening to the financial media.

In this process, you should pay special attention to stocks that pay dividends. On the one hand, they are good investments and, on the other hand, their dividend yield tends to increase when they decrease. It's a mathematical result that occurs because of how they calculate dividend yield - the total annual dividend of a stock divided by its current price.

Take, for example, a company that pays £0.50 per quarter per share, or £2 per share each year. Imagine that it is £80 per share before the stock market crash and that it drops to £40 per share after the crash. The dividend remains the same, but some struggling companies may decide to reduce or stop their dividend. If you divide £2 by £80, you get 0.025, which works out to a dividend yield of 2.5%. But if you divide £2 by £40, you will get 0.05, which is a dividend yield of 5%. If the price drops further to £20 per share, you will get a 10% return.

That's why market declines are good news for dividend investors. Not only do they increase their dividend yield, but they are also a great source of cheap stocks that can give them great growth when the market eventually rebounds.

6. Be patient

Bear markets can reveal the tenacity and determination of a trader, including professionals. While the former may be a time of financial insecurity, history teaches us that they don't really last very long. If you're planning to retire in ten years (or more), you don't have to worry about a bear market.

Bear markets often help highlight good stocks that can usually give you an edge in the ensuing bull market. So don't be in too much of a hurry to get rid of a stock. Watch the company's critical financial signs (like sales and profit growth, etc.) and if the company is doing well, hold on to the stock. Take advantage of the dividends and hold the stocks while they evolve over the long term.

Always make sure you have funds outside the market. This means that you should keep cash in your trading account, or some other place where it is easy to get it when needed. You will need to be ready when the market turns around is full of opportunities to buy stocks at discount prices.

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