Getting Ready for the Next Market Downturn
By Dr. Richard Smith
Are you ready for the next bear market? Have you thought about what it will be like… and how you’ll handle your portfolio when it comes?
If you haven’t given much thought to the topic, you aren’t alone. Most investors have little idea what to do in bear markets. That’s why many investors get clobbered in bear markets – financially and emotionally – with devastating impact on their long-term retirement goals.
It’s a good idea to avoid that (obviously). The proper mindset was captured by Pericles, a Greek statesman from the fifth century BC, who said, “Our job is not to predict the future, but prepare for it.”
We don’t know when the next bear market will begin… and our job is not to guess. The current bull run for U.S. equities, which is now the longest in history by various measures, could keep going like the Energizer Bunny for three months… six months… even longer.
But sooner or later – and sooner is a real possibility – it will come to an end. And another bear market will come.
First Trust, a portfolio wealth manager, did a study of S&P 500 performance dating back to 1926. They divided the S&P 500’s performance into bull and bear market periods, and defined “bear market” as follows:
From when the index closes at least 20% down from its previous high close, through the lowest close reached after it has fallen 20% or more.
Based on that definition, the S&P 500 has seen eight separate bear markets since 1926. The average bear market length, according to First Trust, was 1.4 years. And the average cumulative loss was 41%.
The longest bear market, after the 1929 crash, was 2.8 years. The shortest, after the crash of 1987, was just three months.
What can we learn from this data?
Keep in mind that First Trust measured from the point of 20% decline to the bottoming-out price. In terms of investor psychology, a bear market can feel like it’s longer, because the final bottom can only be determined with hindsight. Many consider the bear to be ongoing for months or even years after a new bull run has started.
The 17th century English philosopher Thomas Hobbes once described the life of primitive man as “nasty, brutish, and short.” Fortunately the life of man has improved. But that’s still a good description of bear markets. Equity bear markets can be painful… and bloody… and they come to an end faster than most would expect.
We can also see that bear markets are potentially devastating for retirement assets. An average cumulative loss of 41 percent – not just on an individual stock holding, but for one’s entire nest egg – is a very tough pill to swallow.
Bear markets can also devastate mental capital…
Which is just as important as financial capital. An investor’s mental capital represents his or her sense of well-being, emotional resilience, and ability to make wise decisions under pressure.
When financial capital is hit, investors lose money. But when mental capital is hit, they lose their nerve and their capacity to be rational, which is sometimes even worse.
Leverage magnifies loses
For unprepared investors, the real pain of a bear market is not just the potential for a 41% haircut from start to finish. It is also in the magnification of losses through leverage.
Many investors use “leverage,” which essentially means adding borrowed money to their own capital in order to increase returns. (This isn’t an exotic concept. If your stock-trading account is qualified to use margin, as many are, that means you have the ability to buy $200 worth of stocks for every $100 in capital.)
Leverage becomes very popular toward the end of a long bull market run. As investors grow more confident, their willingness to use leverage increases. The amount of optimism and leverage tends to peak even as the bull run reaches its climax. This magnifies the pain of the bear market that follows.
Leverage becomes very popular toward the end of a long bull market run. As investors grow more confident, their willingness to use leverage increases.
This is why bear markets can extract a double or triple cost. Not only do they inflict harsh losses on a stock portfolio, they exact a psychological toll, and – especially when leverage is involved – they take away the capacity to generate returns in the next bull phase… which can then reinforce a sense of frustration and despair when investors realizes a new bull run has taken off without them! It’s a truly vicious cycle.
That’s the bad news.
The good news is…
By having a rational plan it’s possible to sidestep all of this – and to actually take advantage of the opportunities that bear markets create.
When a bear market comes, the investor’s first job is to preserve financial capital. This means “avoid losing too much money.” Their second job is to preserve mental capital. This means “avoid losing your nerve.”
As a side note, bear markets are where “buy-and-hold” strategies tend to fall apart because the buy-and-hold approach is just too costly, both financially and mentally, in the face of the brutal losses.
It’s one thing to be confident in buy-and-hold when the major stock indexes have been gently rising for years on end. But it’s another thing when the markets feel like a never-ending sea of red and have felt that way for six months or more.
As it turns out, preserving financial capital and mental capital is a two-for-one deal. Investors can help preserve both by managing their risk, which means sizing positions properly and cutting off exposure to losses before they grow large.
This is where the benefit of having a plan comes in – as Pericles said, not predicting the future but preparing for it.
Preserving financial and mental capital is a crucial step
You can do that by having a risk-management plan, which includes the tools to help manage and execute that plan. Sizing your positions properly is a big part. Having access to reliable signals that warn you when an individual stock (or the entire market) has turned is another big part.
There’s also another key step to surviving and thriving in bear markets: knowing when to get back in.
Buy-and-hold advocates tell investors to hold on like grim death when a bear market comes. They caution against getting out because, as the buy-and-hold advocates put it, “you’ll never know when to get back in.”
Except you can, in fact, “know when to get back in…” as long as you have a plan and the tools!
There are logical ways to define when a bear market is ending
There are also opportunities within bear markets where various industries, sectors, and individual stocks are experiencing bull trends, regardless of what the broad market is doing.
You can identify these opportunities – not in a vague or squishy way, but as defined by market signals that tell you the transition is real.
And this is the place where bear markets provide opportunity – not for all investors, but the ones who were prepared.
It is always the case, almost by definition, that tremendous opportunities are available in a bear market aftermath. That’s because most investors were ravaged by the claws of the bear… and were thus forced to sell at rock-bottom prices.
The biggest and most powerful bull runs begin the moment the bear market ends. Having a healthy supply of financial and mental capital in those situations is a huge advantage, indeed. It’s one of the best things you can do.
Coupled with that, you need the signals to alert you to new opportunities… both during the bear market’s duration (there are always stocks going up… this was even true in the 1930s) and especially when the new bull begins.
Investing in markets without a plan is like going on a road trip without any maps, or going into battle without knowing what kind of war you’re fighting. It doesn’t make much sense. But if you do have a plan, the landscape looks very different.
This is especially true in the context of bear markets.
Are you risking too much?
Investing isn’t a one-size-fits-all process. Everyone does it for different reasons.
And your personal goals have a lot to do with how you decide to manage your investments.
You could be looking to earn enough money in the stock market to send your child to college in 10 years. Or you might want to position yourself to make huge gains from a major macro event that you believe is on the horizon.
Maybe you want to protect yourself against economic calamity. Maybe you just want to continue to generate steady income to maintain your current lifestyle.
Your decision-making process and the risk-management strategies you use will be completely different in each of the above scenarios. It’s important to realize that your goals matter. The more you understand your own goals, the more likely you are to achieve them.
And consistently achieving the goals you set will make you a successful investor…
Let’s face it, no stock purchase will ever be risk-free… Taking risks gives investors opportunities to succeed. But different stocks have different levels of risk… And those levels can vary dramatically. So how much risk is the right amount? Again, there is no one-size-fits-all answer. It all depends on your level of risk tolerance.
Risk tolerance is how much exposure to loss you’re comfortable with. It’s how much you can afford to lose in pursuit of a big payoff… and how long you can wait to get paid.
The amount of risk you take can determine how quickly you meet your goals… or whether you meet them at all. If your goals involve a short time frame, playing it safe might not be good enough. But for someone with more modest goals and a couple of decades to work with, the “slow and steady” approach could be smarter.
Start by looking at your investing goals. Can you reach your goals by gradually growing your money over a long period of time? Or do you have lofty goals that require big gains quickly?
It is always the case, almost by definition, that tremendous opportunities are available in a bear market aftermath.
Also, remember that different portfolios can handle different levels of risk. A large and carefully diversified portfolio can usually rebound from a loss due to a risky investment, while a smaller portfolio could be destroyed by too many risks or even one big risk.
Consider, for example, two portfolios –
one with $25,000 and one with $250,000. Now, let’s look at how different losses could affect them:
Losing $5,000 in the $25,000 portfolio would be devastating. It would cost you one-fifth of your savings. But a $5,000 loss in the $250,000 portfolio would only be 2%.
It’s a simple example. But it’s an important one to keep in mind. And it’s exactly why position sizing is so important to you as an investor.
A large and carefully diversified portfolio can usually rebound from a loss due to a risky investment.
What is position sizing? It’s putting the right amount of money into your investments relative to your total portfolio size. It’s a challenging concept to grasp because you have to think about something that most people don’t want to think about: how much you’re willing to risk losing on any single investment.
A good rule of thumb is to risk no more than 4% or 5% of your entire portfolio on any one idea. If you’re risking 4% of a $25,000 portfolio, you’re limiting your potential loss to $1,000 on each investment. If you’re risking 4% of a $250,000 portfolio, then your potential loss would be $10,000 per investment.
One common strategy uses something called “trailing stops” to limit losses. And an easy way to set those limits is with the “25% rule.” It’s simple: Sell if your investment drops 25% from its highs.
Let’s go back to the $25,000 portfolio. If you’re willing to lose $1,000 on each investment and you’re using a 25% trailing stop, how much money should you invest in each position? The answer is $4,000. If your $4,000 investment falls 25%, you will have lost $1,000 – or 4% of your $25,000 portfolio. That’s far less devastating than the earlier example, where a $5,000 loss would cost you 20% of your $25,000 portfolio.
Again… investing isn’t a one-size-fits-all process. An experienced investor with a good track record of success and a large portfolio can afford to take larger position sizes. But if you’re just starting out, you likely can’t do that.
Decide what your individual investing goals are. Then figure out the amount of risk you’re willing to take in each investment. Use that amount to determine how much money you should put into each position.
Regardless of your goals, losing too much of your money when you’re just getting started in investing is a surefire way to ruin your financial future.
With a rational plan and the right tools – like proper position sizing and knowing your risk tolerance – you’ll be able to confidently make the right decisions… And give yourself the financial and mental capital to successfully grow your portfolio in the face of a bear market.
Dr. Richard Smith has a PhD in Math and Systems Science and is the founder and CEO of TradeStops. He has spent the last 10 years researching and developing algorithms and services that give individual investors the tools they need to succeed and better manage their investments.