If you are going to invest in stocks for any length of time, you should plan for a bear market because one will eventually come along. In the U.S., bear markets happen roughly every four years, and in some markets, they have been even more frequent1. Seeing stocks drop 20% in value – which is the definition of a bear market – can be alarming, particularly if it has been some time since the last bear market. Your first reaction might be to pull out of the market, but the problem with that approach is that evidence shows that for most investors, trying to time the market usually doesn’t work. Jumping into and out of the market typically leads to worse returns than planning for bear markets and sticking to your plan. But how should you do that?
The first step is to explicitly plan for bear markets. More specifically, you should make sure your rate of return on your portfolio is realistic and you test the impact of a poor sequence of returns, including bear markets. We think it’s realistic to assume you’ll receive the historical rate of return, less any expenses you incur in investing. Don’t assume you will beat the market, because few people do. Beyond having a realistic long-term assumption though, you should also check on the risk of a poor sequence of returns.
One way to test sequence of return risk is to assume you encounter a bear market in the first few years of retirement. Historically, even diversified portfolios with a sizable allocation to bonds have dropped over twenty percent, and many retirement plans are susceptible to sharp market drops in the first few years of retirement. A key reason is that in those initial years of retirement, many retirees withdraw a higher percentage of their portfolio than they will later in retirement. If you couple this higher withdrawal rate with a sharp decline in portfolio value, you may not have enough invested when the market recovers to tide you through the balance of your retirement.
Once you have completed your plan, review your portfolio to make sure the two are in alignment. There are a couple of key questions you should ask as you evaluate your investments. First, does your actual portfolio closely resemble the portfolio you stress tested in the plan? Second, do you have a clear understanding of your investments and how they are likely to perform in a bear market? We pay particular attention to the bond portion of portfolios as they should serve as ballast in a down market (but not all types of bonds do). Finally, if you need cash, have you already set it aside or are there conservative investments you can liquidate as needed? We prefer clients have a minimum of one year’s worth of cash in either cash or conservative bonds.
The last thing to consider when it comes to bear markets is what you can do to minimize the stress you feel as the market drops in value. We have found several things to be helpful:
- Look at market history – understand what has happened in past bear markets. How much has the market dropped on average, how have portfolios like yours performed and how long have the downturns lasted? The next bear market probably won’t look like the last bear market, but understanding how your portfolio has performed in bear markets can be helpful in setting expectations.
- Take Control – one of the most challenging aspects of a bear market is the feeling of not being in control as you watch your portfolio drop sharply. The most obvious action to take – pulling out of the market – is one that, as we have shown above, generally does not work. So look for other ways to exert control.If you’re drawing from your portfolio and are concerned about the drop in portfolio value, take a look at discretionary spending and see if you can reduce the amount you withdraw. If you’re still in the saving phase, try to invest more when the market is down. Even the simple act of making an investment when the market is down sharply can be helpful. A few weeks ago after week-after-week of losses, I invested some extra cash when the S&P dropped by nearly 4%. I immediately felt better.
- Understand your plan – a good retirement plan includes stress tests for bear markets. Assuming your plan does, too, take a look at how your portfolio has performed relative to that stress test. If your plan was successful through bear markets and your portfolio performance is still within plan parameters, you should still be on track.
The latest round of market weakness has eased so we may have avoided a bear market once again (at least in the S&P 500). However, at some point the bear market will return, the press will trumpet increasingly dire headlines, and the sharp losses will feel particularly acute after such a long period of growth. So plan for a bear market now, do what you can to reduce your stress during the downturn and stick to your plan.
- Over the last few decades, emerging markets have averaged a bear market every other year. ↩