Everybody’s a genius in a bull market, the old saying goes. But a bear market creates fear, uncertainty and costly mistakes.

The conventional definition of a bear market is a decline in prices of 20 percent or more, lasting at least two months. Whether Wall Street is in a bear market right now depends on what is being measured. But there’s no question this market has unsettled many investors.


Here are 10 ways to avoid permanent losses and crash-proof your portfolio ...

You can experience two types of bear markets, temporary and permanent. Markets tend to go up and down and then back up. In a temporary bear market, you lose 20 percent or more but eventually recover. In a permanent bear market, you lose 20 percent or more of your money and you never get it back. All the historical evidence I’ve seen indicates that a properly diversified portfolio has never suffered a permanent bear market. Unfortunately, some common investor behaviors can easily turn temporary losses into permanent ones.

1. Diversify among many stocks. If all your money is in Washington Mutual (WM) shares, you’re hurting because of the sub-prime mortgage mess. Microsoft (MSFT) shares are still worth less than half their value at the start of 2000. If you own a diversified portfolio, you’re unlikely to suffer that kind of pain. My advice: Own thousands of stocks via mutual funds.

2. Diversify across many sectors. Financial services and homebuilders are doing poorly now. Yet energy, natural resources and export-intensive industries that benefit from a weak dollar are holding up better. If you own the Standard & Poor’s 500, you’re invested in energy, industrials, information technology, consumer products, healthcare, telecommunications and much more.

3. Spread your portfolio among different asset classes. Be sure to look beyond the S&P 500 to achieve this goal. Examples include value, small-cap, large-cap and growth. Every asset class we recommend has a long-term history of success. They have made money despite plenty of temporary losses. Further reading: “The ultimate buy-and-hold strategy .”

4. Spread your investments geographically. I’m not talking about country funds. The answer is not to put some of your money in Brazil, a little in India and some more in Germany. The answer is to diversify throughout the world. International index funds are the best way to do this.

5. Even with all this diversification, you probably still need some fixed income investments such as bond funds. Most investors should not expose their entire portfolios to the stock market. Fixed income funds can be a great stabilizer. Just how much fixed-income you need depends on your circumstances, and figuring this out is worth spending some time with a good financial advisor. Further reading: “Fine tuning your asset allocation .”

6. Consider using a mechanical defensive strategy to limit the size of your losses. Active risk management isn’t for everyone, but it is possible to follow systems that let you invest in an asset when its price is rising and switch to cash when its price is falling, without your having to make any forecasts. Every day that your money is in cash is a day you’re not exposed to a possible bear market. Don’t do this without a firm discipline. You’re asking for big trouble if you base your moves on your emotions or your own judgments about the market. Further reading: “The myths and realities of market timing .”

7. Avoid paying unnecessary expenses. It’s not hard for sales loads, trading costs, management fees and operating expenses to total two percentage points. If you don’t pay attention, you can lose a lot of money and have no way to gain it back. In fact, you can lose more than you invest in the first place. Here’s an example from our investment workshop, “Live it Up Without Outliving Your Money:” If you’re 25 years old and you invest $5,000 in equities every year, a return of 12 percent will make your account worth $3.8 million after 40 years. But if you neglect the expenses you’re paying and your return is only 10 percent, you’ll have only $2.2 million after 40 years. You will have given up $1.6 million, or eight times the total dollars you saved for 40 years.


8. Avoid paying unnecessary taxes. In an actively managed fund, the fund manager decides when to sell and incur capital gains liability that will impact your tax bill. Choose funds in which the management pays attention to limiting your tax liability. Avoid funds that churn their portfolios, buying shares for capital gains that can hurt you at tax time.

9. Don’t panic. Selling an investment after it’s taken a big hit can leave you with a permanent loss. If it rebounds, which it probably will, you won’t be there to benefit.

10. Don’t think you can outwit the bear by avoiding all risk. One of the worst “bears” in the forest is inflation, and it can be especially painful for the most risk-averse investors. If you want to hang onto cash in an environment of 3-percent inflation, you are almost certain to lose purchasing power over the long run. Even staying exclusively in Treasuries or other fixed income securities can’t overcome the combination of taxes and inflation.

Crashes happen and so do those nasty bear markets. But every investor can limit the damage by following these guidelines. Be patient. And if you have trouble keeping track of all these things, a good professional advisor can help you.