the Nasdaq composite and Russell 2000 are already deep in a bear market – which is a drop of 20% or more from a previous high. And after this week’s sale, S&P 500 is now also just a few percentage points away from a bear market.
Walt Disney† Amazon† Metaplatforms† Starbucksand Adobe are just a handful of names in the long list of companies whose stock prices have fallen 40% or more from their all-time highs. Other once-loved growth stocks such as Shopify (STORE 13.85%† and Netflix have seen their stock prices fall more than 75% from their peaks.
Bear markets can create life-changing wealth by providing investors with buying opportunities, but that doesn’t mean it’s time to plunge into the abyss of this situation without a plan. Here are three mistakes worth avoiding during a bear market.
Investing in companies you don’t understand
The easiest way to lose money in a bear market is probably by investing in companies you don’t understand. Several companies have seen their valuations rise to nosebleeds in recent years. Thrill-seeking investors seeking high-risk, high-reward stocks flocked to these names, many of them without understanding the fundamentals. The result was wide swings upwards, followed by catastrophic losses on the downside.
During a bear market, things get very real very, very quickly. An investor who sees his portfolio go from forest green to scarlet red in a few months, without knowing why, is prone to lose his temper and run for the exits. If you don’t understand the businesses you own, it’s hard to know what decision to make and when.
Bear markets are testing fundamentals. Companies with good cash flows and healthy balance sheets tend to survive the bear markets and grow over time. Those that do not tend to be removed.
Anchoring all-time highs as a fair price or a price the stock will reach again
Another big mistake investors can make is thinking that the all-time high is a fair price or a price the stock will someday return to. After all, if a stock has fallen 80% from its high and returns to that high, that would be a 500% return. I’m sorry to say, but many stocks will never reach the all-time highs reached in 2020 and 2021. Or if they do, it could take a long time.
As mentioned above, Shopify’s inventory is down more than 80% from its all-time high. Despite compelling fundamentals, strong growth, a well-run business, and the tailwind of the ecommerce industry, Shopify stock still isn’t cheap. The company has a much more attractive risk/reward profile now that its share price has fallen so much. But that doesn’t mean Shopify should have a market cap of over $200 billion (which it did at its peak) until it proves it can sustain a high growth rate and achieve consistent gross margin.
But just as many growth stocks have gone way too high, others have gone way too low. While Shopify is expensive, the risks are starting to look a lot less scary in relation to the rewards. Shopify has its issues, but ultimately it’s an incredibly well-run business with a lot of growth potential. Probably the worst part of Shopify is the rating. Since that issue is much less of an issue now, it seems like a good time for investors to consider stocks like Shopify.
That said, going into such a stock assuming it will return over 400% in the short term is the wrong approach. Rather, it’s best to approach precipitated growth stocks with quality fundamentals as companies you believe in and feel comfortable with over a period of at least five years.
Gambling on speculative stocks
Another big mistake is trying to catch a falling knife from a company that is down a lot simply because its stock is down a lot. This mistake is a combination of mistakes one and two and a common decision investors will make in a bear market. The temptation to see a stock that has sold out and try to buy the dip without knowing why can lead to painful losses. The percentages may shock you.
Let’s choose Roku (ROKU 11.82%† and Robinhood Markets (CAP 24.88%†† By January 1, both companies were down 50% to 75% from their all-time highs. But since then, each stock has fallen another 50% to 65%.
The math sounds confusing at first, but it makes more sense with real numbers. Let’s say an investor bought a stock in 2021 at $300 per share and then opened in 2022 at $100 per share. That would be a loss of 67%. Four months later, the stock was $50 a share. The drawdown of the high is 83%. But even the investor who bought the stock at 67% at the start of the year would have already fallen 50%.
This exact scenario has played out with many growth stocks falling out of favor. Granted, that doesn’t mean they’re all bad. Some even look like phenomenal purchases now. It’s just to say that just because a stock has fallen sharply doesn’t mean it can’t rile up investors trying to buy the dip.
Let time be your best friend
Instead of trying to be a hero and swing for the fences during a bear market, the best course of action might be to simply save what you can, averaged at the dollar rate in the stock market (especially when stocks are on sale). ), and sticking to quality companies with strong fundamentals and the best chance of weathering this and future bear markets. This plan may not offer the most benefit, but it certainly offers a risk/reward profile that makes sense to most investors.