[Editor's Note: This was originally published in Physicians Money Digest in 2014, but it seems much more timely now. Experienced investors know there is always a bear market coming. Although you never know exactly when, a long-term plan that takes bear markets into account prevents portfolio disaster.
As I update it now in March 2020, the world is wrapped in fear from COVID-19, stock markets are down over 32% from the peak, and nobody knows how long this will last or how deep the drop will be. Although we have technically had two very brief bear markets in the last decade (2011 and 2018), many investors didn't even notice and many “younguns” have never really had these fears for their portfolio before.
While every bear market is unique, those of us who were investing in 2008 have seen this movie before, and we know how it ends, and most importantly, that it does end. There is light at the end of the tunnel, even if you cannot see every step of the pathway through it. If you have a reasonable written plan, now is the time to follow it, not change it. If you do not yet have a solid written investing plan, there is no time like the present. ]
Financial journalists tend to only write about and discuss what to do in a bear market once the bear market has begun.
People are usually reactive, rather than proactive, when it comes to investing. When stocks go up, they buy more. When stocks go down, they sell. This childish behavior accounts for the dramatic differences between investor returns and investment returns extensively documented by firms such as Dalbar and Morningstar.
Buying high and selling low is an all too frequently experienced investment disaster.
A bear market is generally defined as a 20% drop in broad stock indexes. The average bull market is only 41 months long.
History may not repeat itself, but it often rhymes. There is no doubt that a bear market is coming, even if we have no idea when it might begin. Now is the time to make sure you are ready for it. Successful investing is more about managing risk, particularly your own behavior, than anything else.
Don’t Try to Time the Market
Most people, when asked how to prepare for a bear market in stocks, would suggest the obvious and intuitive response: sell your stocks now before they go down.
Unfortunately, market-timing like this is a loser’s game. Not only do you have to time the market successfully once (when to get out), but twice. If you sell a little too early, you will miss out on significant gains at the end of the bull market. If you get back in too late, you will miss much of the subsequent run-up.
In 2009, the market climbed 40% in just 3 months from its nadir. Clearly, market timing is not the way to survive the coming bear market.
While a buy-and-hold, stay-the-course investor may suffer terrible losses from market peak to market valley, he will also enjoy every bit of both of the bull markets bracketing the bear, while minimizing the investment expenses and tax costs inherent in a more active pursuit.
Don’t Despair in a Bear Market
Although not necessarily in astronomical terms, but certainly in investing, the night is always darkest before the dawn. The best returning investments you will ever make will be those you purchase in the depths of a bear market. However, it is extremely difficult to do so.
- Newspaper headlines will remind you every day for months how much money you are losing.`
- The talking heads on CNBC will spend hours daily spouting doom-and-gloom prophecies and bringing every perma-bear guest they can scrounge up.
- Your co-workers will be talking about how they sold their stocks “long ago” at the water cooler.
- Your spouse will look at the most recent account statements and ask “What are you doing with our money?”
- You will see years worth of carefully budgeted 401(k) contributions disappear.
- You may even say, “I should have bought that boat or remodeled the kitchen instead of maxing out the 401(k).”
I can assure you, it will not “feel” right to buy stocks at moments such as these. However, the best thing you can do is to make your investment plan as unemotional, logical, and automatic as possible, rather than going by how you feel.
Have a Written Investment Plan
Now is the time to prepare for the coming bear market and the best way to do so is to write down an investment plan. That plan might say that you will hold 40% US stocks, 20% international stocks, and 40% bonds and that you will rebalance that portfolio once a year.
If you follow this plan, you will find yourself at the height of the bull market with a portfolio with only 30% bonds, and your plan will force you to sell high. At some later point, you will find yourself in the depths of the bear market with a portfolio that is 50% bonds, and your plan will force you to buy low.
This is a winning formula for investment success.
What do you think? What have you done to prepare for a bear market? Comment below!
I have found that having a sufficient emergency fund separate from all retirement and discretionary investing helps to ride out and ultimately profit from bear markets.
I have been confidently waiting for the next bear to roar into the market for about 24 months now….I thought surely it would be here by now and based on your 61 months of math it should be here any day now! Too bad it could be next week or it could be 3 years from now. Guess I will just keep the slow and steady approach like you recommend and I have been doing and rebalance whenever necessary. When I can buy that Delorean and get it to 88 mph I will be a wealthy man!
No kidding! My source for plutonium dried up when Tripoli fell and I’ve had my Delorean up on blocks in the back yard ever since. The lightning is entirely too unpredictable for my investing plan.
Amateurs. Invest in Mr. Fusion. It’s like bio-diesel… it has a questionable ROI compared to lightning though.
I wonder how many newly minted residents would get this reference. I am probably dating myself to admit that I saw Back to the Future Part I in the movie theater (although as a kid).,.
I think one way for young investors who have never lost significant money in a bear market to think about it is to compare their savings rate with their portfolio size. If your monthly contribution is at least 1% of your total portfolio, it will take at most 2 years to recover from a 25% correction. If your monthly contribution is under 1% of your portfolio, you should consider having more significant non-equity holdings to buffer a big drop in the stock market.
Ooh, that’s interesting, I like that.
Behavioral/psychosocial issues aside, financially/mathematically speaking, is there a down side to an all equity index fund portfolio if one is willing to see it through ? ( your point is taken that it is not an easy thing to do)
Mathematically 100% equities wins over the long haul, but it may not be reality for example
You think you can handle the ride, but in reality you may not be able to. If you have 100K invested and it drops to $60K then no big deal, easy to ride out as you continue to contribute. But what if you have $2.5 million. and it drops by $1 Million, 2 years have passed and the markets are still flat, will you still stay the coarse? Will you keep buying into equities? Now what if you are 50/50 equites/bonds? Now instead of having $1.5 million you have $2 million, plus bonds are still paying interest practically guaranteed and you get to reallocate back to a 50/50 portfolio thereby buying into the low market. Much easier to stay the coarse even if it takes years for the markets to recover.
Another situation can occur is the actual length of recovery. What if it takes 5-10 years to break out of the bear market while you are planning on retiring or going part time in 7 years. Now you have to work longer than expected
I think if you are early in your investing career, have a small nest egg with decades to go, then 100% equities is just fine. Otherwise be careful what you think you can handle.
Aside from behavioral issues, there is the possibility that bonds will outperform stocks, even over the long haul. While perhaps not probable, it is possible, and one great non-behavioral reason to include fixed income in your portfolio.
It seems the significant and more probable reason is to reduce volatility during retirement/withdrawal years. Anything else I’m missing (unlikely scenario of bond outperformance aside)?
If the increased shallow risk and the increased deep risk don’t bother you, then no, you’re not missing anything else. However, if you haven’t invested a significant sum of money through a bear market yet (as most asking this question haven’t) I suggest you err on the conservative side with your asset allocation. Your return will only be slightly lower and when you’re young savings rate matters far more, but if you scare yourself silly in your first bear market, it may impact your investing for life. Far better to earn 1% less than to bail out in the midst of a big bear market. Do that once or twice and you might as well have been investing in T bonds or whole life insurance.
We’ve worked on the “sidestepping” of these sigma events ( bear markets ) and reducing portfolio volatility with the use of a counter intuitive, empirically derived tactical asset allocation model. Our last article covered the advent of workers who are behind on their retirement asset accumulation and how they can utilize our model with various style diversification methods to “accelerate” their accumulation. We also know that medical professionals work hard for their money and shouldn’t have to lose sleep over a large equity drawdowns. We share our knowledge with free blog content and publish our articles on Seeking Alpha ( no sales pitches here ).
http://stockmarketmap.wordpress.com/2014/03/05/market-map-portfolio-diversification-with-dividend-growth-and-small-cap-value/
“a counter intuitive, empirically derived tactical asset allocation model” = market timing based on projecting the past forward into the future.
So I ask myself, “Self, why would Market Map want to share this revolutionary money manufacturing technique with me rather than use it to make a bazillion dollars himself?”
And, while I have no idea what this particular technique might be, the answer to similar questions in the past has been because it is either a technique designed to be sold, not bought, or it simply won’t work going forward. Now, let’s read his link:
Let me summarize:
Use a portfolio of Vanguard small value, the tech stock heavy QQQ, and 10 blue-chip “dividend stocks.” But wait, there’s more. You put 20% into SV, 20% into QQQ, and 40% into the large caps. Then, with the last 20%, you switch every 5 years between the large caps and the QQQ/SV combination. You also apparently time the market between cash and equities based on “indicators.”
Okay, that’s unique. Can’t say I’ve seen this particular model backtested before. So what does the author do…well, he backtests it all the way back to…..ready for this…..1993. Uh….okay. You do realize that we have a rather robust stock market database that goes back to 1927, right? How does this particular strategy look if we go back to there? Heck, how does it look from 1973-1993? It’s a bit like the development of a clinical rule. First, you test it against the derivation population. Then, once you have derived it, you test it against a completely separate validation population or two. Have we done this? It doesn’t appear so. This is simply marketing disguised as science, and social science at that.
The problem with using an approach like this is that NOBODY HAS BEEN INVESTING THIS WAY FOR THE LAST 20 YEARS. It’s purely hypothetical. Back in 1993, nobody was going “Let’s put 20% of our portfolio into QQQ.” In fact, as I recall, QQQ didn’t exist in 1993 at all. It was begun in 1999. The Vanguard small value fund was begun in 1998. The approach is basically, “Find something that worked well for the last 20 years and do that.” As we know, this is such a bad idea, that every investment prospectus is required by law to say so.
Your blog advocating this approach is 6 months old. As near as I can tell, your “articles published on Seeking Alpha” are instablog articles, not articles vetted by the Seeking Alpha folks:
“Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors’ articles.”
So at any rate, now we have a derivation sample. Let’s validate it now going forward for the next 20 years. I doubt anyone will be talking about it in 10, and seriously doubt more than a handful of people will be using it in 20. Will they be bazillionaires? Perhaps, but it seems unlikely. Maybe your market timing approach is the smartest thing that anyone has ever come up with and far superior to all the other market-timing strategies out there, but it seems unlikely.
For the casual reader interested in what most investing authorities think about timing the market, check out this list of quotes:
http://www.bogleheads.org/forum/viewtopic.php?t=52517
This is a great snapshot of how to not crumble under the pressures of a bear market, but I was wondering if there is any info or experience out there on how to take advantage of the bear market? In other words, (after reading Grahams Intelligent Investor) this would seem like a great time to purchase undervalued securities. I suppose staying the planned course would be one way, but are there better ways out there? I am a young passive investor very early in my journey and would love some ideas on how to make the most of the bear markets.
“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”
Yes, buying when stocks are cheap leads to better returns. You can do that just by rebalancing. If you want to “over-rebalance” there is an aspect of timing there that might or might not work out for you.
pretty novice investor here so probably kind of a stupid question. let me start with my axioms
1) DJIA is a record high
2) This has been a very long bull market
3) I’ve only had the chance to invest in this bull
4) Bear is coming, hard to know when but probably soon by investing standards
It seems to me that even if I pull everything into cash tomorrow the absolute worst thing that can happen to me is that I miss the remaining bull.
It seems almost axiomatic that selling an index fund right now is “selling high.” Is this not correct?
Lots of people said that in 1996-1997. The difficulty with timing the market is you have to be right twice. Think about how off you would have had to be in the late 90s in order to have been better off riding it all the way up and all the way down and all the way back up again. Come to think of it, that would make a great post, especially when you add in the transaction and tax costs.
Suffice to say, you have to be more accurate at predicting the future than you are likely to be. If you’re nervous, it’s probably because your asset allocation is too aggressive for you. Far better to be a little less aggressive than you could have been and stay the course in your first bear, than to have been a little more aggressive than you should have been and bail out of stocks (perhaps forever) at the depth of the bear.
do you have to be all that accurate? it seems like you are assuming that you need to ride each wave to its very peak.
i’m sure that people way smarter than i have figured this out it just still doesn’t make all that much sense to me.
it’s not at all a question of portfolio composition for me.
That’s a good question. Let’s say your only investment was the S&P 500 Index Fund. You get out a year before the peak, and get back in a year after the trough. How did that do in 2000-2002 and 2007-2009? The data is easily accessible on Vanguard.com for 2008-2009, so let’s use that. The peak for 2007-2009 was about Oct 1, 2007. So let’s say the market timer got out a year before that, Oct 1, 2006. The trough was in March 2009, so let’s say the market-timer got back in after the first quarter of 2010. We’ll ignore any transaction costs, tax costs, tax-loss harvesting, and the effect of ongoing contributions and rebalancing, although all of that would favor the buy and holder. Who came out ahead?
From Oct 1, 2006 to April 1, 2010, the market timer had a return of zero. What was the return of the buy and holder? A 5.17% loss over about 5 years. So, if you’re not adding any new money to your portfolio, have a 100% stock portfolio, have a 100% tax-protected portfolio, and can call the market tops and bottoms within one year, then you may very well do a little better with a market timing strategy. Good luck with that. It seems like a tough strategy to stay the course with, all to save just 5%. You would have been out of the market for 3 1/2 years wondering if you did the right thing. The more likely thing that market timers do is get out late, not early, and that’s not nearly as pretty.
And be very humble about your ability to tolerate a bear market. Lots of people think they can tolerate investment losses, but have never actually done so.
This is the exact topic I was wondering about as I sit twiddling my thumbs wondering if bad things will ever hit. Thanks for thinking ahead, WCI!!
So there isn’t really anything “extra” that needs to be done, right? (Our food storage is stockpiled with all flavors of Alpo.)
Posting here in 2019, 10 years into the bull market now. I recently cashed out several stocks at all time highs and am planning to stockpile money in muni bonds for a while to save up for real estate down payments. Might deleverage some mortgages too (residence and 2 rentals).
I’m avoiding savings accounts–even at 2.5% interest such as Wealthfront–as their real rate of return is negative after tax and inflation.
Just now reading this in 2020, and the current bull market is still ongoing and is now the longest in history. It is not the largest, however, with the S&P 500 up 330% v. the 417% in the 1990s. Maybe it has a little way to go yet.
This post was written in 2014. The bear was in December 2018. It was pretty quick so I’m not surprised you and lots of other people missed it. We’re now in a new bull market.