(MONEY Magazine) – With many stock market indexes recently down 10% or more from their March peaks, I couldn't help but think of a joke I heard during a discussion of bear markets at an investing conference many years back. Two hikers were walking along a trail one morning when suddenly a grizzly bear came charging at them. Both took off at top speed, but the grizzly was gaining quickly. "It's useless," one hiker gasped. "We can't outrun a bear." With that, the other sprinted ahead and shouted back over his shoulder, "Who said anything about outrunning the bear? I'm just trying to outrun you."

I still don't know exactly how this grisly tale relates to market downturns--except to say that whether you're savoring the natural wonder of the woods or the preternatural returns that stocks have provided during the past few years, you never know when you might come face to face with a scary old bear. I'm not enough of an outdoorsman to know what, if anything, nature lovers can do to prepare for a close encounter of the ursine kind. (The nearest I get to the wild these days is chasing errant softballs into the brush in New York City's Central Park.) But I do know that when it comes to investing, you'll survive a bear market in much better shape if you understand a bit about how market meltdowns work, do a bit of prudent planning beforehand, and stay calm while stock prices are being mauled.

The aim of this month's column is to help you on all those counts by answering what I consider the four most important questions about bear markets.

1. What exactly is a bear market? With more than 200 years of stock market history under our belts, you'd think we'd all agree on what constitutes a bear market. Uh-uh. While the generally accepted definition of a bear is a decline of 20% or more in a major stock index, applying that yardstick can be tricky. Take the 17-month 19.4% decline in Standard & Poor's 500-stock index that began in September 1976 and the three-month 19.9% downturn that started in July 1990. Most market watchers would call those setbacks bear markets--as I do--figuring that both were close enough to the 20% cutoff to qualify. The S&P 500's 19.3% decline in 1998, however, is usually considered a correction (generally defined as a decline of 10% to 20%). Why? Because it wasn't very deep and it rebounded relatively swiftly, which shows that bears are often designated as much by emotion as by statistics--not just by how much the market is down but how long the down mood lingers.

There's also the question of which index should be used to designate a bear. In April, the Nasdaq slid 34% from its March high. Yet because the tech-heavy Nasdaq is so focused on one industry, most experts consider it too narrow a benchmark. On the other hand, consider this: As of early May, 60% of the 2,748 stocks listed on the New York Stock Exchange were down 20% or more from their previous highs, according to Birinyi Associates. But does that mean the market was in a bear market? "No," contends Birinyi research director Jeff Rubin, "it's not just how many stocks are down but which ones." To qualify as a real bear market, according to Rubin, the stocks that account for the bulk of the market value represented by indexes like the S&P 500 must be down 20% or more. Clearly, a whole lot of subjectivity goes into bear tracking.

2. How much damage can a bear do? Quite a bit, as the table on page 65 shows. During the eight periods since 1960 that the S&P 500 slipped into a bear market, stock prices on average declined 29.3% over the course of 12 months. Considering stocks' long-term annualized returns of roughly 11%, that means a bear market can easily wipe out two or more years' gains. But, like any average, this one doesn't show just how ugly things can get. In the 1973-74 bear, for example, stock prices dropped for nearly two years, until the S&P 500 had lost almost half its value--48.2% to be exact. Compared with that Ursa Major, even the 33.5% drop in 1987 is only a Pooh bear.

To get a real sense of what it's like to live through a bear, take a look at the last column on the right in that table, which shows how long it took for the S&P 500 to regain its pre-bear peak. This break-even period is important because it tells you that you would have had to hang in almost three years on average--7 1/2 years in the case of the severe '73-'74 meltdown--before stock prices got back to where they were before the onset of the bear.

Now, if you were a true long-term investor who faithfully reinvested all of your dividends in stocks throughout each bear market, the compounding power of those dividends would have shortened your break-even period. In the case of the long and deep '73-'74 bear, you'd have broken even in 3 1/2 instead of 7 1/2 years. But ask yourself: Would you have had the tenacity or blind faith or whatever it takes to keep plowing money into stocks after they'd lost half their value and had no apparent prospects for rebounding anytime soon? Or like many investors who swore that they were definitely in the market for the long term, would you have bailed out?

3. What causes bear markets? Since bear markets typically occur after investors have pushed stocks to valuations that are lofty by traditional measures like price/earnings ratios and dividend yields, many investors assume that outsize valuations themselves trigger a downturn. But, says InvesTech Research newsletter editor James Stack, "valuations don't cause bear markets any more than a rooster crowing causes the sun to come up." Truth is, overvalued stocks can get more overvalued. In December 1996, for example, Federal Reserve chairman Alan Greenspan questioned whether "irrational exuberance" had pushed stock prices to unsustainable levels. Three years after he first uttered that famous phrase, the S&P 500 had more than doubled in value. But that doesn't mean stock prices don't count. The higher euphoric investors push stock prices beyond their fundamental values, contends Stack, the more ferocious the bear will be when it pounces.

If valuation isn't the catalyst, what is? Historically, it's usually been rising interest rates, typically driven by an increase in inflation. Climbing rates hurt stocks in two ways: They raise borrowing costs, which dampens corporate profits, and they make bonds and CDs more attractive to investors, reducing the demand for stocks. In 1973, for example, short-term rates jumped more than three percentage points in response to rapidly rising inflation. Bond rates also began to climb. The combination of rising short- and long-term rates essentially triggered a decline that sent the stock market into what has, so far at least, proved to be the deepest bear market since the Big One, a.k.a. the crash of 1929.

Given the recent turmoil in the market and the fact that the Fed has boosted short-term rates six times between June 1999 and May 2000, you might figure that a bear is lurking just around the corner. Not necessarily. Just because most bears are preceded by rising rates doesn't mean rising rates always lead to a bear. Rates jumped by roughly two percentage points in 1994, an increase that knocked long-term Treasuries for losses of 8% or more and reduced bond traders to tears as their year-end bonuses dropped below seven figures. Still, while higher rates held the S&P 500 to a 1.3% gain in 1994, the market didn't sink into bear territory. In fact, rates dropped again in 1995 and the S&P 500 returned 37.6%, its best year since 1958's 43.2% gain.

4. How should I invest during a bear? Here's where you expect me to dispense a few pearls of investing wisdom to help you emerge unscathed from future bear markets. Sorry. Goldilocks may have been able to have her way with the bears, but it's a lot tougher in the world of investing. For one thing, just because an investment performs well in some bear markets doesn't guarantee it will reprise that star turn in others. According to investment research firm Global Financial Data, food stocks, for instance, actually gained 29.9% in the '80-'82 bear market and fell only 5% vs. the S&P 500's 19.9% drop in 1990. But in '73-'74, the sector was clobbered with a 42.2% loss. Similarly, utilities held up relatively well in the 1987 and 1990 bears but lost as much as the broad market or more in the 1968-70 and 1973-74 downturns.

Even if you manage to pick investments that excel during a bear, you may be doing yourself no favor. As the table on page 66 shows, the five mutual funds still in existence that had the highest returns in the 1987 bear were largely underwhelming performers over the following three, five and 10 years. That makes sense if you think about it. The market spends a lot more time going up than down. So if you load up on stocks that do their best during the occasional downturns, you're essentially setting yourself up for subpar long-term returns.

To me, that means the best way to deal with a bear is to arrange things in advance so you don't have to do a lot of rejiggering when the bear hits. Specifically, I recommend building a diversified portfolio so that when stocks go down--as we know they sometimes will--other assets you own may keep rising. You may lament lost opportunity while stock prices are skyrocketing. But knowledgeable investors take a balanced approach, which, after all, is what owning a "portfolio" is all about.

Obviously, the right stocks-bonds mix for you will vary depending on how you react when you see stock values evaporate before your eyes. But if your portfolio had consisted of 75% large-cap stocks and 25% intermediate-term bonds going into the '73-'74 bear market, you would have suffered a 33% loss--unpleasant, to be sure, but a far cry from the S&P 500's 48% decline. What's more, over the next 10 years you would have earned an annualized 14.1%, or 90% of the S&P 500's return.

Most important, even while in the grip of the bear, you should continue buying stocks with new money you have to invest. That's hard to do when other investors, like those two hikers, are scurrying for safety in money-market funds. Assuming that history repeats and that a bull market follows the next bear, the stocks you buy at depressed prices will likely generate the sweetest returns you'll ever earn.

Senior editor Walter Updegrave is the author of Investing for the Financially Challenged (Warner Books). You can reach him at investing101@moneymail.com.