On March 9, 2015, the Wall Street Journal ran an article titled “How to Survive a Bear Market.” The article highlighted the prediction, by experts, analysts, and amateurs alike, of a market downturn following the six-year bull market beginning March 2009. But the markets proved resilient, and the ensuing 3 years produced a cumulative return of 31.09% for the S&P 500, or an annualized return of 7.34%. Accurate long-term market predictions are a near impossibility, and something Wall Street has been trying to accomplish for decades without success.
We all know investing in the stock market produces a greater return over the long run than safer, less volatile investments, such as treasury bonds. So, logically, we all expect to see downturns and bear markets. Dealing with these downturns and bear markets emotionally when we are in the throes of a market decline is another thing entirely. Once the markets begin to decline, we assume that the decline will continue into the foreseeable future, and we often feel the need to make changes to our portfolio or pull money from the market, “just until things calm down.”
So what is the real answer? Can you survive a bear market? Most investors ask, “Where is the market headed?” The question they should be asking is, “When do I need the money?” We know that bear markets occur on a regular, irregular basis. See the chart below. Bear markets can be a reaction to true economic concerns, but can also be the result of a mini-panic. Recall the intra-year loss of over 19% in 2011 and declines of 12% in the Fall of 2015 over concerns about China’s slowing economic growth.
Surviving a bear market takes pre-planning. Money needed within the next several years should be invested in safe/non-volatile assets to ensure the availability of the money when you need it. Keeping your investments widely diversified will help you capture at least some upside in every asset class, as well as reduce volatility. Don’t take risks with fixed income. That portion of the portfolio is meant to act as a buffer, allowing you to take the equity risk needed to outpace inflation over the long term. High-risk bonds have a propensity to act like equities when the markets are volatile, just when you need the stability the most.
Finally, know that the skill of extrapolating bad experiences into the future is handy for human survival, but doesn’t apply to investing. Learning to stay away from snakes once you’ve been bitten is smart. Assuming the market will continue to decline because it’s already declined 20% is human nature, but not based in fact or on data. In a sense, successful investing goes against so much of what has kept us alive for thousands of years.
The Oxford dictionary defines volatility as the liability to change rapidly and unpredictably, especially for the worse. When we are saving for retirement or relying on our retirement earnings after many years of hard work, this word sounds terrifying. What a terrible idea. Who wants their investment return to change rapidly, unpredictably for the worse? No one. So why do millions of investors tolerate the volatility of the returns in the stock market? The answer lies in the risk return trade off. The more variable an asset’s return, the riskier the asset, the greater the return investors demand from that asset. Whereas investments with no risk offer a small return.
The average annual return on the One-Month Treasury Bill - typically considered a risk-free investment, from 1997 – 2016 was 2.1%. During that 20-year period, investors in T-bills never had a loss, although there were periods after the great recession when returns were zero. Inflation over the same period was 2.1%, leaving investors in One-Month US Treasury Bills with a return after inflation, or real return, of 0% annually over the 20-year period.
Compare that to the popular, but volatile, S&P 500 Index over the same 20-year period. By contrast, the S&P 500 produced annual losses in four out of those twenty years - the greatest being a whopping loss of 37% in 2008. So why would an investor take such risks? Because over the same period the average annual return on the S&P 500 was 7.7% or 5.6% after inflation, providing investors with meaningful real return.
Most investors are only concerned with downside risk, or the prospect of a loss. (I’ve never heard of someone complaining that their upside return was too great.) In fact, historical data tells us that the US market has been negative approximately 25% of the time, or 23 of the last 91 years, from 1926 to 2016 (see chart below). Still, during this longer period, investors were provided with meaningful real return for the risk taken. Per the Center for Research in Security Prices at the University of Chicago, the US Market provided an average annual return of 9.8% from 1926 to 2016, or 6.9% after inflation (2.9% inflation data provided by Morningstar).
When money is invested for the long term, and the investor doesn’t overreact to negative years, the returns are substantially greater. Investing in the equity market will be volatile. No one can accurately predict if a year will be positive or negative, but over history, that volatility has been rewarded by greater return.