For investors in the stock market, one of the challenges is experiencing the market drops that are bound to happen. A number that the media focuses on is a 20% decline in the stock market, defined as a bear market. Each time this happens, some of the characteristics are the same even though the details are always different. In this post, we talk about how to invest through a bear market and what investors can do to prepare.
Take a Long-Term Perspective
For stock market investors, we can look at history to help think about what might happen in the future. As we look at past bear markets, the common themes are unrest and uncertainty.
The unrest may be related to the economy, geopolitics, or government policy. It could be driven by housing, commodities, inflation, debt markets, tax policy or even a global pandemic.
The uncertainty is around how far the markets may fall and how long the rebound in markets will take. There have been 12 bear markets since WWII. For these bear markets, the average decline has been 33% and the average recovery has taken 22 months.
Source: Bloomberg. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is not a guarantee of future results. Actual returns may be lower.
It is not unusual for the market to experience drops in price. In the average year, the market declines 14% from its high.
Source: JPMorgan Guide to the Markets, Q1 2022. Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during a year. Data as of December 31, 2021. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is not a guarantee of future results. Actual returns may be lower.
When the markets have declined 10%+, it has historically been a good time to invest on average, with average annual returns of 10% over the next 3 years.
Source: Dimensional Fund Advisors. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is not a guarantee of future results. Actual returns may be lower.
Stock prices can be very volatile in the short run. This volatility is the price investors pay for strong returns over the long run. Taking a long-term view, the rewards for equity investors have been staggering.
Source: Dimensional Fund Advisors. US Large Cap is the S&P 500 Index. US Long-Term Government Bonds is the IA SBBI US LT Govt TR USD. US Treasury Bills is the IA SBBI US 30 Day TBill TR USD. US Inflation is measured as changes in the US Consumer Price Index. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Past performance is not a guarantee of future results. Actual returns may be lower.
Bear markets are part of investing and negative returns are normal. This volatility is the price investors pay for strong returns over the long run. The average bear market recovery has taken around two years, although there have been cases where the recovery was much shorter and much longer.
Develop a Plan
With this historical perspective in mind, it is important to develop a plan for your investments.
This plan should be built around what you are trying to achieve with your finances. This could be providing income in retirement, or it could be purchasing a new home.
Two key considerations as you build your portfolio are when will you need the funds and how much risk are you comfortable with.
When Will You Need the Funds?
A key part of the investments piece of the plan is thinking about when you will need the funds. Funds for college tuition next year should be treated differently than savings for a retirement 10 years away.
We expect that bear markets will happen. One way to manage for this is to position portfolios so that we aren’t forced to pull funds from the stock market at the wrong time. To do this, investors can keep part of their portfolio in more steady assets like cash or high-quality bonds that can be a source of funds when they need distributions from their portfolio.
How Much Risk are You Comfortable With?
Another key part of the investment plan is each investor’s comfort level with taking risk. If an investor can’t stomach the volatility of their portfolio leading them to sell at the worst times, it is unlikely they will be a successful long-term investor. Thus, a thorough understanding of risk is an important part of planning as well.
The plans and portfolios for each investor can vary widely, depending on what they are looking to achieve and what their situation in life is like.
If you haven’t done this already, it is not too late. There will be more down markets to navigate.
Building a plan for your portfolio allows you to be prepared instead of being reactive. Bear markets are part of investing and creating plan that takes this into account will enable you to better manage through it.
Don’t Let Emotions Pull You Off Course
Once there is a plan in place for the portfolio, you are only part of the way there. The next (and often more difficult) step is to execute on that plan.
There are a lot of moving pieces to your financial picture and sticking to your investment plan is a key part of it.
If we let the day-to-day movements of the markets get ahold of our emotions and cause us to change course, the likelihood of being successful falls.
When a bear market is happening, there can be a temptation to sell your investments in hopes of buying back in when the market has bottomed. This requires two correct decisions to be made and in our experience is difficult to do. In particular, this requires one to buy when the situation may look the most dire, a tough thing to do for an investor focused on avoiding losses.
That doesn’t mean that adjustments should never be made to portfolios in a bear market. Changes may be appropriate as part of your investment plan, whether it is rebalancing or tax loss harvesting, for example. Also, plans may change as life happens and your situation changes, leading to a reassessment of your portfolio.
Making market timing calls is difficult. Focus on sticking to your long-term plan.
Takeaways
Bear markets are tough to invest through. There is always uncertainty around what the future holds and it can be challenging to see the path forward. Its important to have a plan for your portfolio that is built around your specific situation and goals. This increases the chances of successfully investing through bear markets. If you would like to talk with a financial planner about whether your portfolio is built to support your unique goals, please schedule a call here.