How to survive a bear market
Wednesday, January 02, 2019
When a bear market begins, get rid of everything and move into cash!
No, that’s not what I’m recommending. In fact, it’s probably about the worst injury you can inflict on your retirement account.
But during the years I spent as a Registered Investment Advisor, whenever a bear market approached worried clients would begin calling, wondering if they shouldn’t weather the coming storm by doing just that — selling everything and moving into cash.
It’s human and natural to try to reduce risk. Someone who doesn’t understand the importance of risk reduction in life may not be on the planet for long. Those who don’t understand the importance of risk reduction in their financial lives won’t do well either.
A Brief Dip into Data
But how do you reduce risk in a way that allows your retirement account to survive a bear market? I’m going to recommend one quite simple way of doing that, but, first, let’s consider a few market-related data points.
First of all, as we know, the stock market is profoundly cyclical. On a graph, bull and bear markets describe a wave pattern, where the bull or upward part of the wave lasts on average around nine years and the downward bear market part of the wave lasts around 16 months. The overall decline in value in the bear market phase of the cycle averages slightly over 40 percent.
It’s less well-known that in the first two years of a recovery — the first two years of a bull market — the market gains about 65 percent from the bottom of the bear market trough. According to a ValueScope study available to its clients, the fastest growth occurs in the first three months, with average gains of 43 percent in the first year.
Here’s an example of how this affects a portfolio worth $300,000 at the peak of the bull market. The average 40 percent loss in a bear market reduces the value of this portfolio to $180,000, which sounds devastating. If this were the end of the story, a good way to respond to an impending bear market might well be to just get out and wait for another bull market to establish itself before buying back in.
But that 40 percent loss isn’t the end of the story. The average gain of 65 percent in the first two years of the following bull market brings the value of the portfolio back up to $297,000. In other words, if you don’t get out when the market begins falling, but stay fully invested, within two years of the following bear market your stock portfolio will be within 1 percent of its previous peak.
The Fallacy of Getting Out to Stay Safe
One cautious response to this information is OK, that’s the average: but what’s the worst case? The worst case seems pretty bad. In the last bear market, which hit a low in 2009, the market lost over 50 percent of its value.
Also, not every bull market high reaches the average 480 percent gain. The bull market that began shortly after the turn of the century and that ended with a horrifying collapse in 2008 had a total gain over five years of just a little over 100 percent. That’s OK, but not great. With this in mind, you may consider that when a bear market begins, there’s nothing wrong with getting out.
But there are several things arguing against this view:
Since no one can predict the future of the market, the best you can do is rely on historical averages, all of which point toward staying in the market through the bear market phase, since the likelihood is you’ll be made whole again within two years of the recovery.
A bull market isn’t one long sweep upward. On average, a bull market has a correction every year before resuming its upward climb. And, of course, following the last correction is the correction that keeps on going and becomes the next bear market.
How can you tell which of these corrections continues and begins the next bear market? You have no way of knowing.
If at some point, you decide to exit the market because the risk of staying in seems too great, you can either make that decision early or you can hang on until it seems quite clear the bear market has begun. If you exit early, the likelihood is that you’re exiting at a correction point and the bull market will soon resume without you. Economists call this the “lost opportunity cost” — the money you could have made by sticking it out.
If, on the other hand, you tough it out, waiting to get out until the market has dropped significantly, what you’ve then built in that loss. In fact, economists note that this is one behavior that significantly lowers the market returns of the average individual investor.
While it may be uncomfortable to watch your portfolio decline in value in a bear market, eventually you’ll recover that money and go on to make more. That’s why nearly every investment advisor recommends staying in the market.
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