Are we in a bear market?

If stocks have declined 20% from a recent high then technically we are in a bear market.

And even if we aren’t right now, rest assured, we can’t avoid them. Sooner or later one will come along so it is worth knowing some facts about bear markets.

The facts (from CNBC)

• A bear market is when stocks decline 20% or more from a recent high.
• Since World War 2, bear markets have lasted 13 months on average.
• Stock markets tend to lose 30.4% of their value.
• It usually takes 22 months for the stocks to recover.

The key takeaways being stock markets tend to lose 30.4% of their value and they usually take 22 months to recover.

Add bonds to your portfolio

So if you can’t afford to lose 30.4% of your portfolio, it would be a good idea to have some bonds in your portfolio. Bonds don’t go up as much as stocks in the good times, but they don’t go down as much as stocks in the bad times either.

Highly rated government bonds are just a bout as safe an investment as you can make. [you can read more about them here]

What percentage of bonds you have will depend on your time horizon and ability to tolerate risk. The more risk tolerant you are and the longer your time horizon the less bonds you need.

Your risk tolerance basically describes your ability to watch your money go down in value without panicking. If your stocks went down 50% in 2008 and you didn’t bat an eyelid perhaps you don’t need any bonds.

However, if you can’t stand the thought of your money going down even temporarily you might be better off with all bonds. [You can read more about that here]

When it comes to time horizon, the longer the better. You may get some different opinions about how long “long” actually is but I think anything over 10 years can be considered long.

If it usually takes 22 months to recover the price of stocks in bear market you’d definitely want to cut out stocks if you need your money within 22 months.

Of course, in an ideal world you wouldn’t need to ask “are we in a bear market?” You’d know it was coming so you’d take your money out of the market right at the start. Wait for the stock price to hit the bottom, and then buy back all your stocks. You’d make a lot of money if you could do this.

Timing the bear

This is called market timing and if you want to try it, good luck. Market timing has been proven to be next to impossible.

Here’s a quote from the founder of Vanguard, John C.Bogle from his book Common Sense on Mutual Funds.

The idea that a bell rings to signal when investors should get into or out of the stock market is simply not credible. After nearly fifty years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.

John C.Bogle – Common Sense on Mutual Funds.

The graph below from Vanguard shows a 30 year period from 1986 until 2016. The blue line is the return of the FTSE All-Share Index, which is an index of the UK stock market. The grey line also shows the FTSE All-Share Index, but doesn’t include the 10 best days.

FTSE All-Share Index – 1986 until 2016

If you had missed those 10 days you would have lost just about half your return.

Have a plan (and stick to it!)

That means, for the majority of investors, the best thing to do in a bear market is to already have an investment plan in place and then stick to it.

Easy for me to say! Watching the price of stocks go down for 13 months wouldn’t be the best way to spend time for most people.

When stock prices are going down, you just need to remember stocks are on sale. You can buy them at a discount. Warren Buffett explains it best:

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period?

Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the ‘hamburgers’ they will soon be buying.

This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

Warren Buffett

That doesn’t mean you should rush out and buy stocks every time prices go down. At the end of the day, you don’t know how far down they are going to go.

You might buy them today after a 20% drop only to find they drop a further 20% tomorrow. Deciding when is the best time to buy something goes back to market timing, which as already mentioned is extremely difficult to get right.

A sensible way to invest is through dollar (or pound) cost averaging and rebalancing, and it is worth looking at these two individually.

Defending through rebalancing

Rebalancing means realigning your portfolio back to your original investment plan. This is usually a split between bonds and stocks.

So if your plan says you should have 50% in stocks and 50% in bonds, then you should periodically rebalance to this amount. More often than not stocks are going to have performed better over a given period.

Let’s say they’ve done really well over a year. Because of this, the value of your stocks has gone up, so that now you have 70% of your money in stocks and only 30% in bonds.

You now need to rebalance to get back to your 50/50 allocation plan. You do this by either selling some stocks, buying some bonds or a bit of both.

In a bear market, the situation may be reversed. Your stocks are likely to go down in value in relation to your bonds. So let’s say, it is a bear market and the value of your stocks has gone down so much that now your portfolio is reversed.

You now have 70% of your money in bonds and only 30% in stocks. To get back to your 50/50 split, you need to either sell some bonds, buy some stocks or a bit of both.

The magic of this system is that it causes you to subconsciously buy low and sell high. You don’t need to make a decision, your portfolio is telling you what to do.

Protection through dollar cost averaging

If you dollar cost average and rebalance, a bear market should be a walk in the park for you. Dollar cost averaging is where you drip feed your money in at regular intervals.

Some people do this annually, some people do this monthly. It doesn’t matter how often you do it as long as you stick to the plan.

If history is anything to go buy the stock market is going to go up and down through bubbles and crashes, bear and bull markets. Sometimes you’ll be paying over the odds for your investments, but at other times you’ll be buying bargains.

In the end the price you pay will even itself out, so that you end up paying the average price. Moreover, because the prices tend to go up over time, paying the average price will enable you to get market returns and the markets have proven again and again that they are generous over time.

Basically, if you are dollar cost averaging your money into the markets, you’ve got 22 months to buy shares as a discount prices.

That said, it is important to realize that we are just talking about averages here. During the next bear market stock prices might drop a lot lower than 30.4% and it might take a lot longer than 22 months for prices to recover.

Diversification to fend off the up and coming pain

And this brings us to our last point, diversification which Burton Malkiel (in a Random Walk Down Wall Street) describes as:

The only free lunch in investing.

Burton Malkiel

Diversification is a simple concept. Essentially, don’t put all your eggs in one basket.

Think about this. If you invest in one company and you choose badly and that company goes bankrupt you may lose all your money.

On the other hand, if you invested in 100 companies the chances of all of them going bankrupt are pretty low. Basically, the more companies you invest in the better and safer you will be.

I know what you’re thinking….. Wouldn’t it be better to just invest in all the good companies that are going to do well and skip all the bad companies?

Unfortunately, choosing which individual stocks are going to do well is an almost impossible mission for the average investor. In fact, most professionals seem to struggle with it, too.

But there is one way to guarantee you’ll own all the best companies and that is to buy all the companies.

If you buy all of them you are guaranteed to own the ones that do well. Yes, you’ll also own some rubbish but the good companies will more than make up for it.

The more companies you invest in, the more diversified you will be. Diversifying your investments into as many companies as you can is a sensible decision. In fact, you don’t need to stop there. You can diversify into different business sectors and geographies.

Nobody knows what the future holds. The stock prices of individual companies crash all the time. Whole sectors go down from time to time and on occasion entire countries’ stock markets go down.

What does history tell us?

If we want to have a look at how stocks have performed historically a great place to start is the The Dow Jones Industrial Average (the Dow), a stock market index that represents 30 large publicly owned companies in the US.

During the crash of 1929 and subsequent Great Depression it lost almost 90% of its value and took 25 years to recover. Both the UK and US markets have crashed many times and always recovered.

However, that doesn’t guarantee that they will do in the future, though. We only have to look at some other stock markets around the world to see what might happen.

At the time of writing the Shanghai and Shenzhen stock markets in China are down about 40% from what they were prior to crashing about a decade ago and the Japanese stock market is about 40% down from what it was before it crashed about 30 years ago.

Crashes do happen and they can take a long time to recover. Historically, the Dow Jones has crashed by over 40% eight times.

Imagine if you were Japanese and your pension was down 60% from what you started with 30 years previously!

Being diversified could have prevented such heavy losses. I don’t think Japanese investors will asking why diversify.

The bottom line.

The bottom line is that unless the future vastly differs from the past, being diversified, having enough bonds in your portfolio and sticking to your plan should prove prosperous in the long run.

So, the next time you find yourself asking “are we in a bear market?” Remember, if you’ve got an investment plan in place, and you stick to it, the answer shouldn’t matter one way or another.