CNBC Explains

8 things you need to know about bear markets

Tim Mullaney, Special to

As Wall Street comes off one of its worst weeks in four years, and a wild Monday, investors are wondering how long the correction will last, and what the future holds as angst builds over global growth fears and coming U.S. interest rate hikes.

The Dow is now gyrating after it plunged to 16,450 Friday and experienced an intra-day swing of near 1,100 points on Monday, leaving it more than 10 percent below its record close in May. The Dow hit an 18-month low at 16,106 on Monday morning before it trimmed losses. The NASDAQ is down 11 percent from a record high reached earlier this year and is on pace for its worst month since November 2008.

To help investors make sense of the chaos, here are answers to the most frequently asked questions about bear markets.

A trader works on the floor of the New York Stock Exchange.
Getty Images

1. What is a bear market?

The usual definition is that a bear market happens when stocks decline at least 20 percent from their peaks. A correction is when stocks fall 10 percent. Since a recent high of 2132.82 on July 20, the Standard & Poor's 500-stock index is now down 10.1 percent—barely a correction, and a long way from a bull market.

2. How often do corrections and bear markets happen?

From 1900 through 2013, there were 123 corrections (about one per year) and 32 bear markets (one every 3.5 years), according to Ned Davis Research.

3. How long do they last?

In the average correction, the market fully recovered its value within an average of 10 months, according to Azzad Asset Management. The average bear market lasts for 15 months, with stocks declining 32 percent. The most recent bear market lasted 17 months, from October 2007 to March 2009, and shaved 54 percent off of the Dow Jones Industrial Average.

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Bear markets are usually shorter than bull markets, retail brokerage house Edward Jones said in a report last year. Despite the pullbacks, the S&P 500 has returned an average of 9.9 percent a year, including dividends, from 1900 through 2013, and returned 13.7 percent last year. So far this year, the S&P is down 6.6 percent before dividends.

4. What sets off a bear market?

The bear markets of the last 50 years have had many different causes. Sometimes it's an external shock, often caused by politics—the 1973-74 correction set off by the rise of the Organization of Petroleum Exporting Countries is an example, as is a 1990 bear market set off by Iraq's invasion of Kuwait. So, too, was the 1982 bear instigated by the Federal Reserve, which raised interest rates to punishing levels in a successful bid to crush inflation.

Sometimes bear markets happen because the market decides economic fundamentals simply can't support stock prices. An example is the post-2000 U.S. bear market, when the Internet and telecom bubbles burst. And sometimes it's because economic facts change in ways that make investors change their mind: the 2007-2009 bear market, as the housing market tanked, is the best recent example.

One thing that turns a correction into a bear market can be investor psychology. Since much of investing, especially in the short term, is about trying to guess what other investors may be thinking and react accordingly, selling can breed more selling. That is, people who think other people are selling may try to get out of positions before they lose more value, depressing stock prices in the short term.

Read MoreSmall caps join S&P, Dow in Monday plunge

The current correction is closest to the overvalued-asset model, thanks to Chinese stock prices that had reached unsustainable levels. But the slowdown in China's growth, especially its exports, also rattled faith. And what's happening now shows what happens when corrections get a head of steam as investors get scared.

5. Statistically, when are we due for a bear market?

Now. According to Edward Jones, the last one began nearly eight years ago, twice the post-1900 average duration between bear markets. The last real correction in the S&P was in 2011, when a one-two punch of European debt fears and Congress' nearly shutting the government before cutting federal spending with unemployment still at 9 percent caused a 21.6 percent drop in the S&P between May and October. Depending on the index you use, that one may have even been a bear market: The Dow Jones Industrial Average dropped by "only" 19 percent.

6. How do you protect yourself?

The advice many Wall Street firms are giving this week applies to most corrections: This is a time to be more fundamental than ever, for two reasons.

First, momentum stocks are not done getting hit. As psychology turns more bearish, fewer investors are willing to bet that trees will grow to the sky at uber-hot (pun intended) public companies like Tesla Motors and Netflix. Each is down roughly 22 percent from 52-week highs. So, investors trying to make quick money should avoid momentum names. Second, timing the bottom of a correction or bear market is next to impossible. Guessing that $100 is the floor for Netflix, for example, is a dicey business; there really is no way to know what other investors are thinking in real time.

The corollary is that investors should bet on what they think will happen over the medium to long term, stripping out their inclination to guess what other investors will do this week or this month. If you think electric cars are going to take over the world, for example, it might well be smart to snag some Tesla while it's on sale, if you can afford to wait for the bounce back.

7. Should older and younger investors behave differently?

It depends on whether they need short-term cash at their disposal. For millennials just getting going on their 401ks, it's probably a good time to boost contributions or shift the mix of funds in retirement accounts to be more aggressive (younger investors should usually be fairly aggressive anyway, since they have decades to recover from short-term bear markets).

Older investors who need cash returns like dividends should mostly sit tight, or shift asset mixes more toward U.S. stocks, since the U.S. has the world's most fundamentally strong and stable economy right now. U.S. company dividends are not in apparent danger. But older investors tempted to try to snag some Apple or Facebook on the cheap might want to wait for clearer signs of stabilization before trying to make an opportunity of the sell-off.

In general, the smart play for both groups is to hold onto the stocks and funds they have rather than cash out at low values, and let the gyrations now affect mostly the professionals who are judged by quarterly or annual results.

8. Are bull markets dangerous too?

Of course. Every bear market is preceded by a bull market that went on a little bit too long, or went up more than fundamentals warranted.

The U.S. bull market that preceded this correction, or bear market if things go that far, was the as of June.

Even in bull markets, volatility can hurt short-term returns: Volatility spiked in 1997 and 1998 even as indices moved higher. But the recent bull market has been marked by low volatility. Now many experts expect volatility to pick up as the U.S. economy improves more and interest rates begin to rise.

When that will begin has always been anyone's guess. With markets in turmoil around the world, it's even more up for grabs.