How to Ride the Bear: Think Rationally and Plan Strategically.
The US stock market index, also known as the S&P 500, has dropped by 25% since its highs in November 2021. US bonds have also posted large losses this year, marking the worst year on record for some bond indexes. As investors well know, these declines have resulted in some rather large reductions in portfolio values.
Price declines are hard on investor psychology. Even though we know that bear markets are a normal part of long term investing, they are not fun. It can be tempting to run away or sell. But if we use rational thinking and strategic planning, we can actually take advantage of them and improve returns in future years.
To do this, we need both perspective and time-tested approaches.
On Bears and Bulls: US Market History since 1900
First, the perspective.
Across a 50-year investment time horizon, an investor is likely to experience six recessions, 10 bear markets, and 11 bull markets.
The US stock market is in the midst of its fourth bear market since 2001. There have been 23 of them since 1900, with a recession occurring during 15 of those. Bear markets have occurred roughly every 5 years, but have been occurring less since World War II. Their average decline has been -36% and they have lasted roughly 9 months.
In contrast, 24 bull markets have occurred since 1900. They have lasted an average of 2.7 years, and during them stocks have gained an average of 114%. They have followed each of the bears, fully recovered the losses from them, and ultimately led to new all-time highs.
So what can we glean from this? Large stock declines (bear markets) are a regular part of the investing cycle. The recovery period often takes several years, but there is always full recovery. 100% of the time.
Portfolio Strategies During This Bear Market: Two Investor Scenarios
Now that we understand the history, we can apply time-tested approaches to weathering the current bear market. To do this, let us consider two investor scenarios.
First, some general considerations and caveats. The recent rise in interest rates caused bond prices to fall in 2022. However, looking ahead though to 2023, investors are likely to find quality bonds yielding more than 5%, the highest bond yield in nearly 14 years. Similarly, cash is now earning interest again for the first time since the Global Financial Crisis, with money market rates nearing 3%.
As for stocks, given that they are volatile and can take years to move through a full economic cycle, only long-term investment money should be allocated to them. And the markets may not be at their lows yet for this cycle. However, investors wanting to use history as a guide may be comfortable being more aggressive in their allocation to stocks. Those believing this current cycle is more complex or will take longer to recover might take a less aggressive stance.
Investor One lives off her portfolio. She needs 5% per year and wants to assume a longer than normal recovery period of 5 years. A prudent approach would be to set aside 18 months of cash and reserves into money market funds for safety and liquidity, anticipating a recession that could last through the end of 2023. A minimum of 25% of her portfolio should be in money markets, cash and bonds that mature in 5 years or less. She can seek longer-term gains from stocks and other investment opportunities with the remainder of her portfolio. These could include longer-dated bonds and other securities, with an equity allocation of 60-70%.
Investor Two also lives off his portfolio and needs 5% per year. But he wants to assume that this bear market could take 8 years to fully recover. Given this, in addition to setting aside 18 months of cash, he will need a minimum of 40% of his portfolio in short-term and safe investments and an allocation of 40-50% into stocks.
For both of these investors, using the stock premium as a requirement, adding stocks when they have declined by 30% would give the highest probability of earning the historically average 10% return over a 5-year holding period. In a perfect scenario, several index levels or time horizons would be set, and at each triggering event (time or price level), stocks would be added to the portfolio. By choosing several price points, each investor has a better chance of entering the market at good levels rather than hoping to pick the bottom.
By allocating portfolios in a manner that solves for the current year's need, and then solves for next year and the year after, and so on, both of these investors can maintain a portfolio that provides safety and income for their known needs while taking advantage of lower-priced stocks.
Of course, these are highly-simplified examples of sound portfolio allocation strategy. Every investor is unique, and their need for cash flow and their tolerance for portfolio volatility should be factored alongside the uber-rational math of historic returns.
To conclude, the best approach to investing in the current bear market is to remain emotionless, use rational and historic data to guide decisions, and strategically position portfolios to take full advantage of the opportunities.
*The foregoing content reflects the opinions of Van Hulzen Asset Management DBA "Van Hulzen Financial Advisors" and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.