There is no doubt that a bear market is coming, and now is the time to make sure you are ready. Successful investing is more about managing risk-particularly, your own behavior-than anything else.
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. It has been 61 months since the end of the last bear market in March 2009. The average bull market is only 41 months long. In fact, our current bull market is the second longest the US has seen since 1932.
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.
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 investing 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.
Read investing history
Every bear market feels like the world is going to implode and that your money is gone forever. The best way to give yourself perspective in the coming bear market is to have a thorough understanding of what has happened in the past.
Once you understand that every 3 to 5 years or so an equity investor will lose 20% or more of his investment, then you will expect the coming bear market and be able to deal with its consequences. You will also develop more faith in the markets. They have survived the Global Financial Crisis, currency meltdowns, wars, political turmoil, terrorist attacks, and the Great Depression.
While there are no guarantees in life, it is highly likely markets will survive whatever triggers the next bear market.
Don’t overestimate your risk tolerance
I frequently run into novice investors who describe themselves as having a high risk tolerance. If this is you, I would ask, “What evidence do you have that you have a high risk tolerance?”
The best indication of what you will do in the next bear market is what you did in the last one. Did you sell at the market low? Did you have trouble bringing yourself to rebalance the portfolio? Did you continue to buy more stocks throughout the bear, or did you put your new purchases on hold?
Your answers to these questions provide significant insight into your own behavior and risk tolerance. If you have only been investing for 5 years or less, then the truth is that you have no idea what your risk tolerance is. It might be high, but everyone thinks their tolerance is high in a bull market. It is far better to slightly underestimate your risk tolerance (and miss out on a tiny bit of gains) then to slightly overestimate your risk tolerance, and trigger an investment catastrophe by selling low in the next bear market. Do that twice in your career and you may be working for an extra decade.
Make your asset allocation a little more conservative than you think you can handle. Then during or after the next bear market, if all is going well and you feel like you can handle it, you can increase the level of risk you are taking.
Early in your investing career your investment returns are swamped by new savings anyway, so losing out on a little bit of return won’t hurt you much.
Use a diversified portfolio
A properly diversified portfolio protects you from market downturns. You want several different asset classes (different types of stocks, bonds, and real estate) so that some zig when others zag. It is far easier to tolerate a stock bear market when your bonds have had a nice bump, your precious metals fund is skyrocketing, and your real estate investments are holding steady.
But the time to implement a diversified portfolio is now, not after you have lost 20% of your portfolio.
Aim for long-term success
During your investment lifetime, you are likely to pass through 5 to 10 bear markets. The sooner you learn to invest successfully through them, the more likely you are to reach your investment goals.
Remember, you are not investing money that you need in a year, 5 years, or even 10 years. Even if you are on the cusp of retirement, the vast majority of your portfolio won’t be needed for 10, 20, or even more years. Develop a reasonable, written investment plan and follow it to achieve long-term success—the only kind that really matters.
James M. Dahle, MD, FACEP, is not an accountant, attorney, insurance agent, or financial advisor. He blogs as The White Coat Investor and is the author of the best-selling The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing.