Your bear market survive-and-prosper plan

As a person that likes to have all the tinned food in our kitchen cupboards facing outwards (it's neater and saves time), you can imagine how much attention I pay to my finances.

The first rule of financial planning is to protect what you've already got. You probably won't be surprised to learn that I control my SMSF with a steely eye and near-perfect administrative skill [this is almost frighteningly true-Ed]. I also have a will and plenty of insurance. And I've got a bear market survival plan.

Bear markets occur every five years or so but few of us have a plan to deal with them. That's a big mistake. Bear markets are stressful; trying to plan how to deal with one when you're in the midst of it is difficult. The time to plan is when things are going well, as they are now, not when the proverbial has hit the fan.

The GFC taught us that a bear market will probably change most people's lives for the worst but a well-conceived bear market plan could change yours for the better. So here are the three lessons I learned from that period. Each should help you turn panic into fortune.

1. Get rid of mistakes

Bear markets are difficult to deal with because falling share prices create fear. Once that creeps into your thinking you'll start asking questions of your stocks and yourself that you didn't beforehand.

This leads to indecision and recency bias, where you might start undervaluing businesses by extrapolating recent, temporary events. In other words, you'll start looking for reasons not to buy cheap stocks.

The easiest way to think clearly and rationally in a bear market is to sell out of any stocks that you don't know well; that are too risky; or that you've established an emotional attachment to.

Michael Steinhardt, one of the world's most successful traders, used to periodically sell his entire portfolio to clear his mind and allow him to focus on assembling the safest and cheapest portfolio he could. You might even be able to utilise the tax losses when your fresh portfolio comes roaring back.

2. Look for the best opportunities

Having cleared your mind, you'd think it would be easy to select the best opportunities. But there are reasons why you might not.

First, we tend to stick to companies and industries that we know well. Whilst you should understand the businesses you own there will often be a sector or a company that's easy to understand and far cheaper.

The A-REITs became very cheap during the GFC because of their huge debt loads and failed overseas expansions. We were familiar with them and were able to recommend many of the hybrid securities these businesses had recently issued. These were safer but still offered plenty of upside. We couldn't have predicted the amazing returns they delivered. You often find the biggest bargains in the strangest of places.

Not every bear market is the same, either. Some stocks will unnecessarily suffer far more than others. These are the stocks you should aim to own. But what should you do if you exhaust your funds and share prices keep falling?

3. Sell cheap for cheaper

This is the most important point to appreciate if you are to take advantage of a bear market. During the GFC virtually every stock went down. But over the course of the bear market some stocks fell much harder than others.

By the time Flight Centre reached a bottom below $3.50, it had fallen around 90%, by which time I had exhausted my funds and didn't want to use my margin loan in case the share price kept dropping (as Keynes said, 'the market can stay irrational longer than you can stay solvent').

This is quite normal. To quote Jeremy Grantham, 'only sleepy value managers buy brilliantly cheap stocks: industrious, wide-awake value managers buy them when they are merely very nicely cheap, and suffer badly when they become – as they sometimes do – spectacularly cheap.'

By the time Flight Centre bottomed most investors would have had their brain fried. A price fall like this induces all kinds of concerns, including wondering whether the business is a going concern and if so, when the pain might end.

When fear is this pervasive you need to be invested in the cheapest stocks possible. Making these decisions could be the most important of your financial life. That means selling cheap stocks for extremely cheap stocks.

With net cash on its balance sheet Flight Centre had next to no financial risk. Before the recent share price falls it ended up increasing 15-fold. In comparison, Woolworths' share price only fell 32% during the GFC, which is one of the reasons why its share price has only increased 36% (to its recent highs) since then.

Did that mean Woolworths was poor value in the wake of the GFC? Not at all. But Flight Centre was better value. It's a mistake to buy the companies we've always wanted the chance to own at a good price instead of getting the maximum bang for our buck.

Of course, you'll never know when things have hit rock bottom. So start every day with the same question: If I could create my portfolio from scratch, would it contain the same stocks as it does now?

Next bear market a great opportunity

If the stocks in your imaginary portfolio are different to those in your actual portfolio, sell the cheap stocks you already own for even cheaper stocks that you don't. This is perhaps the only time we'd recommend absorbing some brokerage costs.

In summary, when a bear market strikes you need to be able to act rationally. That might mean getting rid of any stocks playing with your emotions in favour of buying the cheapest and safest stocks. That might mean buying stocks that you'd never considered before and selling cheap stocks for ones that are cheaper still.

By following these rules, and using our research as a means to identify incredibly cheap stocks, you'll be able to confidently build a dirt-cheap portfolio in the next bear market. It could be a great opportunity to change your financial life for the better and we're determined you don't let it go to waste.