How to Invest During Bear Markets and Recessions

Economists' definition for recessions has shifted over time, but one thing's for certain: Recessions cut deep across stock market history. The Great Recession and financial crisis of 2008–09 remains a fresh memory for many market professionals. The sharp and short bear market in U.S. stocks in 2020, caused by the escalating COVID-19 pandemic, led to an uneven bull market through much of 2021. Today, the market still looks choppy. For all the talk about resiliency in the stock market, there has been a significant amount of churn beneath the surface.

That doesn't mean investors should abandon the stock market. Quite the contrary. Investing should always be a long-term disciplined process that involves diversification.

Recessions happen for different reasons and often coincide with or accompany bear markets in stocks. But many fundamental principles of investing and portfolio strategy remain constant.

So how can investors prepare for and invest during a recession and bear market? Examining how stocks have responded in previous recessions, as well as common mistakes investors make, can help inform and enlighten your portfolio strategy. Here are a few basics on recessions and markets, plus mistakes to avoid during a pullback.

Recessions have traditionally been defined as two or more consecutive quarters of shrinking gross domestic product (GDP). But according to the National Bureau of Economic Research (NBER), which is considered the official arbiter, the definition of a recession today is more nuanced and incorporates other economic indicators.

A recession "is a significant decline in economic activity spread across the economy, lasting more than a few months [and] normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales," according to the NBER website.

Most, but not all, recessions have included two or more quarters of declining real (inflation-adjusted) GDP, according to NBER. The economic downturn following the September 11, 2001, terrorist attacks didn't have two consecutive quarters of declining GDP, but it still qualified as a recession. By contrast, in the Great Recession of 2008–09, four out of six quarters posted negative GDP.

NBER's call on 2020 included a peak in economic activity in February that was followed by a "drop in activity [that] had been so great and so widely diffused throughout the economy that the downturn should be classified as a recession even if it proved to be quite brief," according to the site. By its definition, the trough that followed the peak only lasted for one month, April 2020.

Historically, recessions have been triggered by a few factors, including a supply or demand shock in a global commodity like oil. Recently, for instance, the COVID-19 pandemic exposed instability in the complex global supply chain that created a wave of supply shocks rather than the more commonplace demand shocks that are more pervasive in expansions.

Another form of recession could be driven by the Federal Reserve. For example, in the early 1980s, the Fed sharply hiked benchmark interest rates in an effort to tamp down soaring inflation. If the central bank is too hawkish in its monetary policy, or not accommodative enough, economic growth can suffer.

Another form of recession is sort of a credit "reset," a period of rapid deleveraging in the wake of an asset bubble bursting, such as what happened in housing (the 2008 financial crisis) and technology stocks (1999–2000).

Economies and markets move in long-term cycles, with peaks and troughs that can be many years apart. The 12 U.S. recessions since World War II lasted about 11 months on average, according to NBER. Going back to 1854, 33 recessions averaged about 17.5 months.

Over recent decades, economic expansions have gotten longer and contractions shorter—April 2020, for example—although that doesn't necessarily mean the current downturn will be short-lived. The S&P 500^® index (SPX) and other widely followed market gauges often serve as the canary in a coal mine.

Typically, when we enter a recession, it's coming off a period of euphoria or, as former Fed Chairman Alan Greenspan coined, "irrational exuberance," which creates lofty valuations for stocks that the fundamentals might not support.

But if investors and traders get a whiff of recession, such sentiment rapidly reverts. As a result, the SPX and other financial market benchmarks usually provide signals of trouble ahead.

U.S. stocks' record bull run came to an abrupt halt in 2020 before picking up steam again that summer. The SPX posted a then-record high in February 2020 before tumbling some 32% a month later as the COVID-19 gripped the nation. That was well beyond the 20% decline that defines a bear market. There have been 13 bear markets since World War II that posted declines of 32.5% on average and lasted about 17 months from peak to trough, according to CFRA, an independent investment research firm.

The bull market that followed underscored the pent-up demand lockdowns created for consumers and investors alike. From the 32% dive in 2020 until December 31, 2021, the SPX shot up nearly 108%—albeit through a bumpy period.

But as always, past performance doesn't guarantee future results.

In a word or two: speed and volatility. The SPX took only 22 calendar days to sink into bear market territory in 2020, compared to an average of 251 days for the other 12 post-World War II bear markets.

The 24/7, lightning-round nature of today's markets combined with a global health crisis on a scale unlike anything in the modern era created a particularly volatile mix, making it one of the fastest and deepest market downturns in history. That magnitude of those highs and lows, coupled with loss of life, might have created exponentially more stress, anxiety, and fear that continued to rock the markets.

Though volatility and price swings lead to lots of market drama, at the end of the day, most market analysts believe the fundamentals of stock investing remain firmly in place. That makes it particularly important to try to keep emotions in check, maintain a disciplined investing strategy, and avoid these three common investor mistakes during market downturns.

Nose-diving markets are often fueled by panic selling, which any investor with a long-term plan should avoid getting sucked into. Unload stocks during a slump, and you may just be locking in losses and eliminating any prospect of gains if prices recover. Most market specialists agree the more prudent approach is to ride out the volatility and wait for the recovery. History shows the best opportunities to accumulate assets often come after the worst period for markets.

But again, past performance does not guarantee future returns.

Many economic readings are lagging indicators—snapshots of a previous month or quarter. Investors might consider macroeconomic data in the context of company or industry fundamentals. Looking at macro data by itself can potentially cause you to be late to react to what the market is doing. A better path might be to focus on valuations and the prevailing market sentiment of asset classes as well.

Too many eggs in one market sector basket can be a recipe for trouble, and bear markets can change the way some companies are valued. For example, before the 2008–09 financial crisis, many financial companies were considered blue-chip, high dividend-paying stocks. But as some of those companies collapsed, their market value largely disappeared. Lacking diversity can leave some investors with stocks that have been repriced permanently.

When the markets get turbulent, consider talking to an advisor or other market professional, someone who's ridden out rough markets before and could help you navigate through uncertainty.

Above all, don't let emotions get the best of you. In other words, check your emotional temperatures, turn down the noise, and separate what you know from what you don't know.