How to invest in a falling market

Some investors see a falling market as an opportunity to buy into good companies at a discount. But that’s only one potential way to get a bear market working in your favour. In this guide, we go over this and other strategies, plus the pros, cons and risks of investing when markets are falling, and how to do it.

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Strategy 1:

Choose stocks that will bounce back

How do you pick stocks that will recover the losses they make in a bear market? Some have provisions in place to prevent them from falling into liquidation during a fall – such as owning assets with a higher value than the value of their debt. Look at the earnings and debt values of companies and compare them year on year to see if they are growing or shrinking.

Amazon is an example of a brand that’s been growing year on year. It suffered in the coronavirus stock market crash in early 2020, with its share price dropping from its last peak of US$2,170.22 (£1,630) on 19 February before the crash, down to US$1,676 (£1,260) on 12 March – a huge 23% decline.

But it proved it could bounce back and more. By 14 April, its price was at US$2,283.82 (£1,716).

Getting a great stock while it’s falling in value can be an opportunity – it’s like finding it on sale. If it bounces back, you have yourself a profit. But be mindful here. If you buy a stock and it continues to decline, it needs to rise again by more than that for you to make your money back.

If you’d invested in Amazon at its lowest point on 12 March, buying just one share at US$1,676 (£1,260), then sold it just over a month later on 14 April, you’d have made around US$607 (£456) (before any trading fees or foreign exchange fees).

How do I choose?

There are some signs to look for if you’re considering this strategy (past share price performance is not the basis for a wise choice). Look at the company financials, such as the sales and profits, and work out the “price to earnings” ratio (P/E ratio). This is just the share price divided by the earnings per share. When comparing P/E ratios, the higher, the better.

You should also search for the company in the news to check for red flags such as an accounting scandal or unethical behaviour. Such issues can impact the share price.

Strategy 2:

Check out the dividends

If a company is in a bear market but is still paying dividends, then it’s a sign that it’s feeling confident and still earning a profit. This might be a good opportunity if you’re looking for dividend income. If the company can pay out while its stock price is falling, chances are that it’ll pay out when it’s rising, although as with anything in investing, it’s not guaranteed.

How do I find out which stocks pay dividends?

You can usually find out the dividend yield on the trading platform that you’ve chosen to use. If there’s information about the company financials, it will be in this section. The dividend yield is the amount paid in dividends per share, divided by the current share price per share.

It’s worth noting that because the stock price moves all the time, so does the dividend yield. This sometimes makes it look like the yield is particularly high and it’s therefore a great investment, when in reality it’s high because the stock price has recently gone down. Don’t use this information alone to make a decision – always look at other financial information, too.

Strategy 3:

Diversify your portfolio

Even with the most thorough research, you can’t be sure which stocks are going to bounce back and which will never recover. It’s smart not to put all your eggs in one basket at the best of times, and that’s especially the case in a falling market.

To help protect yourself, you’ll probably want to diversify your portfolio, which means spreading your investments between different companies, sectors and countries. This means that if one of your investments unexpectedly goes bust, you haven’t lost everything and can still make a profit overall.

How do I diversify my portfolio?

A way to do this without too much effort on your part is to invest in exchange traded funds, which is an easy method of diversification. This also has an additional benefit, which brings us to our next point.

Strategy 4:

Rotate through sectors

The economy tends to move in cycles. This creates trends, which analysts use to pick stocks that tend to do well at certain stages in the cycle. The idea is that investors can make hay while the sun shines (or start investing in umbrellas when winter’s coming).

What is sector rotation?

Sector rotation is when investors move money between sectors based on what’s happening in the economy. It’s a strategy based on cyclical movements in the economy.

Stock markets don’t work exactly in line with the economy or its cycle but generally anticipate the cycle, trying to predict what will happen in the coming months. This means that you might see the stock market start to fall long before the economy does, but you’ll also see it recovering before recovery is apparent in the economy.

The economic cycle

This is the cycle that the economy tends to follow, generally in this order. It’s not uncommon to see the economy skip a stage, though. Tap or hover over the image of each stage for more details.

How does the cycle help me when investing?

In the early and mid-cycle stages, businesses tend to thrive and consumers want to spend, so investors tend to choose stocks that are “wants” rather than “needs”. So cars, luxury goods and holidays, rather than food, water and energy. These stocks are called “cyclical stocks”.

In the late and recession stages, when interest rates are falling and consumers don’t want to spend much, investors tend to move their money into “defensive stocks”, which focus on basic needs, like energy, food and water.

How do I rotate sectors?

The easiest way to rotate is to invest in exchange traded funds (ETFs), as sector rotation is typically built-in. ETFs are a collection of investments grouped up into one fund. They usually track indices or specific sectors.

If you decide to rotate your investments manually, then it’s a bit more work. Start by researching the current stage in the economic cycle and what’s next. If the UK is in a recession, for example, research which stocks might do well in the early or mid-cycle stages. This can help you choose the right types of stocks, rather than ones which may not have good longer-term prospects.

Strategy 5:

Short stocks you think will fall in value

“Shorting” or “short selling” is at the riskier end of the spectrum and not for beginners. It’s a trading strategy that lets you take advantage of a stock’s value going down. We’ve explained the basics in our guide to shorting.

For this option, you’d focus on the stocks that you expect to go down. This means that you still need to do some research into which stocks are doing well and which aren’t doing well.

Pros and cons of investing in a falling market

Bottom line

There are great potential opportunities to be had from investing in a falling market – if you have the nerves for it. But it takes research, and it’s not for the faint-hearted. If you tend to watch your investments like a hawk, you’re likely to be tempted to sell them if there are further negative movements. That might be a sign that this type of investing isn’t for you.