Steps to take to avoid common investor mistakes in a bear market
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Through the end of September, the S&P 500 had declined three consecutive quarters and lost nearly 24% of its value.
Unfortunately, the bond market failed to provide the protection to which investors are accustomed when stocks are selling off, as the aggregate bond index was off nearly 15% over the same period. Does this mean we are currently in the midst of a bear market?
According to investor.gov, a bear market is defined as a time when stock prices are declining and market sentiment is pessimistic. Most definitions include language referencing a 20% decline in a broad stock market index lasting at least 2 months. Based on the previously described standards, most investors would agree we are currently in a bear market.
Experienced equity investors are accustomed to shrugging off short-term losses. Entering the calendar year 2022, the S&P had absorbed a decline of 10% or more in 10 of the last 20 years with an average decline of 15%. Investors with a moderate risk tolerance are less likely to be accepting of their results this year. Conservative investors may be facing unprecedented losses falling outside the range of what would be defined as a statistically normal outcome for their investment strategy. A moderate portfolio with a 60% stock and 40% bond allocation (using the S&P 500 Index and Aggregate Bond Market Index), had lost 20% through the end of September, which would be the worst year since 1937.
Once an investor experiences losses beyond their acceptable threshold, the temptation to abandon the current strategy intensifies. Every investor is going to lose money in their lifetime. The key to success is avoiding the urge to lock in losses when times appear the bleakest.
It is also important to remember that most bear markets are brief and you are destined to experience several bear markets in your lifetime. Using the 20% decline definition per above, the average length of a bear market 9.6 months and one occurs every 3.6 years. Understanding the history of market corrections may help you navigate through these challenging periods.
We have highlighted a few steps you can take to help resist the urge to make decisions that could derail your retirement planning and long-term financial goals.
Understand risk mitigation strategies
You do not need to have a comprehensive understanding of bonds or standard deviation to understand risk mitigation strategies. A basic understanding that stocks, bonds and cash equivalents offer varying levels of risk is an adequate first step. Allocating a portion of your capital to each of these asset classes — based on your willingness to accept risk — is step two. The challenge is resisting the temptation to deviate from this approach based on how the market is performing or the news you are receiving. Increasing risk tolerance due to fear of missing out is typically where investors initially go wrong.
If you have not made this mistake at some point in your lifetime, you are in the minority. Picture a scenario where the economy is strong, stocks quickly run higher, investors purchase equities at higher prices, and then the same investor gets whipsawed by the correction. If we know stocks are highly likely to recover their losses over time, why is risk mitigation important?
A frequently overlooked approach to investing is winning by not losing. Limiting the downside generally enhances your odds of a successful outcome over a defined period, as illustrated in the following statements:
- 10% loss requires an 11% subsequent return to recover your initial investment;
- 20% loss requires a 25% return to break even; and
- 50% loss requires a 100% return to recover your initial capital.
If the last bullet does not seem realistic, consider the following example:
An investor placing $100,000 into a growth stock, which subsequently declines 50%, now has a $50,000 position. The growth stock would have to double in price (100% return) for the value to return to $100,000.
High-quality bonds, treasury bills, certificates of deposit and money market funds are examples of vehicles investors can use to limit the downside.
Maintaining discipline and resisting the urge to take excessive risk by chasing returns will prevent you from experiencing the whipsaw effect when markets correct. The investments you find boring will be the most rewarding when you need them most. They also can be used as a source of assets to fund the purchase of stocks when rebalancing after a market sell-off.
Refrain from reacting to news
Watching the news any time the stock market is selling off will convince most viewers that another financial crisis is inevitable. Financial media needs ratings to sell advertising, and they know negativity keeps viewers watching. What many consumers of financial media miss is that the news being reported has already been priced into financial markets. The stock market and bond market are not necessarily concerned with a quarter of poor financial data. Each market is forward-looking, attempting to determine how the economy will be functioning in 12 months.
The S&P dropped 25% in 2022 when unemployment was at 3.6% and consumer spending was at record levels. Investors took losses because the market expected higher interest rates, increasing unemployment and a decline in consumer spending, all of which would lead to lower earnings for publicly traded companies. Sometimes the market is wrong while trying to predict the next 12 months. The S&P 500 rallied more than 15% this summer when housing prices cooled and gas prices sunk, leading to the belief inflation had cooled. Late summer delivered reports of double-digit increases in the cost of food and rent, confirming the fight against inflation was far from over.
A study of neuroeconomics helps us to understand our brains are wired to work against us when it comes to investing. The natural human reaction is to go into flight mode when news is negative. Losing money triggers a deep emotional reaction, and that reaction is the preservation of capital. Unfortunately for us, the damage is done, and the market is likely closer to recovery once our instinct takes over.
Potential cost of timing a reentry point
Timing the market is difficult — you have probably heard this phrase a dozen times. When economic conditions deteriorate, there are times when the odds are high that the data will get worse. Correctly timing a sell-off is difficult but not impossible. The challenge is you must be correct twice when making a market timing decision. Many professional investors have gained notoriety for predicting the financial crisis and various other bear markets. The news we don’t hear is when these market timers reinvested. How many invested in March of 2009 and made 80% in the next 13 months?
Cashing out your investments is costly because the recoveries are sharp and swift. Once the news is positive, a sizeable portion of the gain is likely in the rear-view mirror. Missing the bounce is costly.
In fact, as the first chart shows, the 15 best days in the market since 1950 have occurred after severe market corrections. Further, as the second chart demonstrates, if you missed the best 10 trading days in the market since 1950, your returns were more than cut in half.
These statistics are powerful, and they are the reason astute investors don’t engage in all-in and all-out strategies. Timing the market once is difficult, but timing it twice is nearly impossible.
Conclusion
Surviving a bear market is extremely challenging and requires a high level of discipline. Congratulations if you have successfully navigated through tumultuous periods before. That experience will serve you well while dealing with today’s challenges.
Following the steps outlined above may not make you feel better while experiencing losses. Nonetheless, our suggestions will position you to benefit from the inevitable recovery. The authors welcome your questions.
Reference:
Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group, www.ojmgroup.com, where Andrew Taylor is a partner and wealth advisor. You should seek professional tax and legal advice before implementing any strategy discussed herein. They can be reached at mandell@ojmgroup.com or 877-656-4362.
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