In last week’s post, I walked through the challenges of market timing strategies in investing. The buying low and selling high that characterizes an ad-hoc approach doesn’t work, and it can be tough to stick with a more formal market timing strategy. Finally, there is little empirical evidence that formal market timing strategies work. So where does this leave an investor, particularly when a bear market comes along?

We think there are 4 keys in helping clients weather market downturns, and in order of importance they are:

  • Portfolio construction
  • Cash management
  • Rebalancing
  • Tactical decisions

How you build your portfolio – which asset classes you use and in what proportion – is by far the largest factor in determining portfolio return and volatility. Diversification should be a given in portfolio construction, and if you have a diversified portfolio, the various asset classes will perform differently in different investing environments.

As an example, conservative fixed income may well increase in value in a bear market as investors flock to safety while it will perform relatively poorly in a bull market. Thus, when a bear market hits, a diversified portfolio will decrease in value, but not all holdings necessarily lose value and the more conservative holdings should help limit the decrease. This was the case in the 2007 to 2009 downturn, when the Barclay’s aggregate bond index was up 4.2% at the same time the Russell 1000 index was down over 42%. While this may not matter as much if you’re not drawing funds from your portfolio, it is very important to those who depend upon their portfolios and it’s one reason retirees tend to have more conservative portfolios.

Cash management is also important for those clients who depend upon their portfolio for income. As a rule, our goal is for clients to have one year’s cash set aside – either within the portfolio or in an outside account. This cash, coupled with the more conservative fixed income funds should cover several years’ worth of needs assuming no more than 4 to 5% of the portfolio value is withdrawn annually. In past downturns, balanced portfolios have recovered in value in 3 years or less, with the dot com bust being the one clear exception. Based on this, an allocation of years or more in cash and conservative fixed income should allow you to hang onto holdings that are down in value until the market recovers.

The third item listed above, rebalancing, is a method of reducing risk. One characteristic of the latter stages of a bull market is a seemingly inexorable string of new market highs. Quite often though, those highs are driven by investor euphoria – or fear of being left out – as opposed to a growing economy and rising corporate profits. Rebalancing takes some of these gains off the table, with proceeds often going to safer assets like fixed income and this increased allocation to safer assets will provide a cushion in bear markets.1

The last approach above – tactical allocation – is perhaps the most challenging. Tactical allocation involves making changes to the long term strategic allocation for temporary reasons. One of the most frequent drivers of tactical allocation are valuation of different asset classes. One class may be particularly cheap compared to another, thus leading an investor to sell some or all of the apparently overvalued asset class in exchange for the bargain.

One of the biggest challenges is that mis-valuations can persist for some time, trying an investor’s patience in maintaining the tactical allocation. Nevertheless, we believe that from time-to-time, allowing for modest deviations from the strategic allocation can be beneficial, and in bear markets the benefit would be reduced portfolio losses.

For many investors, remaining invested through a bear market can be challenging. When the media is hyping market losses daily and investors are headed for the exits, it can be tough to maintain a long-term focus. However, history is clear that doing so is far more likely to succeed than market timing. If you have a solid financial plan in place, maintain a long-term investing focus and make the actions above part of your investment process, it isn’t likely a bear market will upend your financial goals.

 

1. Interestingly, research has shown that rebalancing reduces long term return by a bit, but it does help reduce overall portfolio risk and keep your portfolio in line with your risk tolerance.

Micah Porter, CFA, CFP® is a fee-only financial planner in Atlanta (Decatur), Georgia. For more information please contact us.