How To Survive a Bear Encounter

What should investors do in a bear market?

During the stock market close in late December the S&P 500 index, which is our main barometer for the U.S. stock market, is down 19.7% from its September 2018 all-time high. This is just 3/10 of 1 percent shy of the accepted definition of a bear market. For the year, the S&P 500 is now down just over 12%. It is worth noting too that a number of our favorite, well-known, large-cap rising-dividend stocks are down 30% or more. So whether we are technically in a bear market or not, investors, including some of the good families for whom I work, are undoubtedly feeling some degree of anxiety over watching their portfolio values declining.

The purpose of today’s talk is to address these concerns – and I don’t mean in a rah-rah pep talk kind of way or in a meaningless, Polly-Anna optimism, don’t worry, this will all get better soon kind of way either. No, the reason why I am calm and collected in the face of this selloff is that we planned for and thoroughly expected a bear market to occur – not because I have any great clairvoyant superpowers, but rather because bear markets are and always have been part and parcel of investing.

In today’s presentation, I will refresh with you the steps we have taken to plan for a bear market as well as the academic research underpinnings for this guidance. At the most basic level, the steps that investors should take to prepare for a bear market are really not all that different from the steps you would take to prepare for an encounter with a real live bear if you were planning a hike in grizzly country. As someone who has both a research background in bear markets and who has professionally lived through three historic bear markets over the past 31 years, you can think of me as your experienced wilderness guide.

Bear Encounter Survival Tip #1 – Know your surroundings

In a grizzly country and in the investment world there are three simple guidelines for preparing for bear encounters. The first is to know your surroundings. In the wilderness, this means that humans need to understand that if they are hiking in areas where bears live, the possibility exists that they will encounter a bear. Hiking in groups, carrying bear-spray and making lots of noise while hiking to avoid surprising a bear are all common safety tips for entering that environment.

When entering the stock market, all investors should know that the stock market can decline – sometimes dramatically. To prepare for this, investors should not have all their money in stocks, and, specifically, your asset allocation should have enough money out of the stock market so that you could go at least a few years without ever having to liquidate stocks to meet your living expense needs.

One of my most common refrains over the years has been that a key to retirement income sustainability and to successful investing in general is to avoid having to sell stocks when they are depressed. In addition to getting this asset allocation correct from the outset, the equivalent advice to hiking in groups is to diversify efficiently. In investment parlance, this is referred to as eliminating non-systematic risk. In plain English, the concept is that there is greater risk in owning a concentrated position in an individual company than in owning a bunch of companies in different industries or the entire market indices.

Bear Encounter Survival Tip #2 – Prepare yourself mentally in advance

The second piece of survival guidance is to prepare yourself mentally for how you should react in advance of an encounter. In the wilderness, guides typically brief hikers on bear behavior and provide advice on how to react to different types of encounters that might arise, such as encountering a mother bear with cubs or a male bear that may be exhibiting signs of aggressive behavior. The financial planner’s role is not all that different.

The possibility of a bear market encounter is a topic raised in virtually every meeting and financial review call and is a frequent topic in the FPH monthly client newsletter. In terms of how to react, I believe I have told each and everyone one of you that when a bear market approaches, I will advise you to ignore the news media hyperbole and that I will be advising you not to sell or to try to time your exits and entries from and into the stock market. While there are always pre-determined conditions under which it might be wise to sell securities, selling due to a broad-based market decline is not one of them.

In our communications, I have also done my best to remind you that the possibility of bear encounter is indeed real. In 1987, the stock market fell 23% in one day! From 2000-2002, the stock market lost more than 50% of its value with the bursting of the dot com bubble and the 9/11 terrorist attacks. From 2007-2009, the stock market fell more than 50% again with the trigger being the sub-prime mortgage bubble. It would be foolhardy for investors to believe that such encounters will not happen again.

However, what makes preparing psychologically for the current bear encounter admittedly a bit more challenging is that there have been no bear sightings in a while. With the end of the last bear market in 2009, there is an entire generation of millennial investors who have never participated in a major market decline.

It is one thing read about bears, but it is quite another to encounter one with your real-world portfolio. In the wilderness, it may be challenging for a guide to get a group of hikers to take his or her advice seriously if there have been no bear sightings in the area for more than a decade. Such complacency and naivete are undoubtedly coming home to roost with investors today as well.

Bear Encounter Survival Tip #3 – Don’t Panic

This brings us to bear survival tip #3, which is “Don’t Panic!” In grizzly country, the best advice for close encounters with bears may actually be what not to do. Specifically, don’t panic and run. This instinctive human reaction may send a clear signal to the bear that you are prey. Given that a bear can run at 40 miles per hour over rough terrain while the fastest human tops out at around 27 miles per hour in perfect conditions on a flat track, your odds of running away without getting mauled are not good.

The same form of advice applies when facing stock market bears – don’t panic and run away. Last week, I met with a new client at our office who recounted how she had lost more than half of her money in the 2007-2009 bear market. I asked her what she meant by “lost” – did she mean that she sold her stock market exposure when the market was near its bottom or merely that the market value had temporarily declined by 50%?

She confirmed that latter. I then explained to her that if she had sold, she would very definitely have realized a significant loss, but, by holding onto her portfolio, she did not really lose any money. In fact, she confirmed that her portfolio today was more than double what it was worth before the 2007 bear market began.

Given that the stock market has recovered from 100% of previous declines, common sense suggests that the odds of a successful outcome favor the “buy and hold” approach, while panic selling may result in your portfolio being mauled.

Summary

In sum, the reason why FPH clients should not be terribly concerned in the face of portfolio declines caused by the current bear market is that we fully expected that something like this would happen eventually, and we have planned for it. To reduce non-systematic risk, we rely heavily on index funds and ETFs for the equity portion of client portfolios.

For some clients, we have also constructed diversified portfolios of rising dividend companies that should continue to pay and increase their dividends throughout the downturn. We have also tried to make sure that money with near term objectives is not exposed to the stock market and that you have sufficient assets allocated to stable investments, such as cash and CDs, that you will not have to liquidate stocks while they are down to meet your income objectives.

Lastly, we agreed at the outset that we will not try to time the stock market and that you should plan on holding stocks through any bear market that we may face. In most client portfolios, the anticipated holding period is “forever” or until you need the money.

I should also mention that nothing in this approach to bear market preparation is proprietary to me. This is not J.R.’s Great Unifying Theory of Investing. I did not think any of this up by myself. Instead, the advice I provide is grounded on a large body of published academic research. Specifically, the Efficient Market Hypothesis states that the stock market is extraordinarily efficient in its ability to immediately incorporate new information and that, at any particular moment in time, it reflects all known information and all future return expectations.

As such, it is impossible for investors, including professional portfolio managers, to “outguess” or time the stock market. Similarly, Random Walk Theory states the near-term direction of the markets is inherently random unpredictable. Therefore, forecasts about the near direction of the markets by so-called market guru’s are worthless.

Together, these two long-established principles of stock market investing provide the basis for explaining why so few active portfolio managers outperform unmanaged index funds. They also dispel the myth of the so-called “smart money,” and make a compelling case for “buy and hold investing.”

I sincerely hope that today’s message provides clarity and reduces any anxiety you may be feeling about the current market conditions. As always, I am available to address any lingering concerns with you individually as well. Thank you for listening. Aloha.

Related Reading:

Behind the Market Swoon: The Herdlike Behavior of Computerized Trading (Wall Street Journal)

Yet another study shows that market timing doesn't work (Motley Fool)

Why the Fool Doesn't Recommend "Market Timing" as a Strategy -- Even Now (Motley Fool)

Busting the Myth of Market Timing (Forbes)

Random Walk Theory (Corporate Finance Institute)

Efficient Market Hypothesis (Corporate Finance Institute)