The way you navigate a bear market in stocks makes the biggest difference to your long-term returns on your investment.
This is important to remember at all times, but especially when the stock market is going down sharply. No one knows if the weakness in the US market is the start of a bear market, but we know it will happen sooner or later. So now is a good time to choose a strategy that you can live with in this bear market.
Much depends on getting that right. Indeed, Jeremy Grantham of Boston-based GMO argues that the next bear market “could very well be the most important event of your life as an investor.“
So I find a silver lining in the Monday market downside: It forces us to face how we would likely react during a full-blown bear market. If you’re worried about a 2% drop, imagine if the S&P 500 SPX,
plunged 57% (like during the financial crisis) or 49% (like when the dot-com bubble burst).
Confronting these unpleasant memories is necessary as the all too common model is to throw caution to the wind when the market is high and then throw in the towel at the bottom. This is the complete opposite of what you should be doing, of course, because it means you are buying high and selling low.
Read: Expect a correction of 10% or worse in US stocks by mid-August, according to this proven track recorder
Even professional stock advisers are vulnerable to this pattern of behavior. At the peak of the US market in October 2007, for example, with the start of the bear market induced by the Great Financial Crisis, the model investment newsletter portfolios tracked by my Hulbert Financial Digest were on average 58% invested in equities. At the bottom of the market in March 2009, 28.4% of these portfolios were in equities.
As you can also see from the graph below, the same pattern happened when the dot-com bubble burst. At the peak of the US market in March 2000, the average exposure level for model newsletter portfolios was 69.5%. At an October 2002 low, it was 38.9%.
It is crucial for you to break this pattern. Granted, it is unrealistic for you to be able to identify the precise high and low, which would allow you to have a higher level of equity exposure at the bottom than at the top. A more realistic goal would be to determine the level of exposure to stocks that you can maintain constant throughout a bear market.
A 100% equity exposure level is not permissible for most of us. As Claude Erb, a former fixed income and commodities manager at mutual fund firm TCW Group, once told me in an email: “People who can really handle volatility of a 100% equity portfolio are either catatonic or dead. “
This psychological truth is illustrated by these investment bulletins whose model portfolios were fully invested in stocks at the peak of the October 2007 bull market. Their portfolios were only invested 26.2% in stocks at the March low. 2009, more than 70 percentage points less. In contrast, consider advisers whose recommended equity exposure at the October 2007 high was between 40% and 50%: not only were their equity exposure levels not lower than the March 2009 low, but they were were actually slightly higher.
So while these more conservative portfolios might have looked silly when the market was up, they definitely had the last laugh. They were in a good position to take advantage of the stock market rebound from the March 2009 low.
Being only 40% to 50% invested in stocks may not be the right level of exposure for you. But you shouldn’t waste time finding the right level. In the trough of the next bear market, you’ll be glad you did.
Mark Hulbert is a regular contributor to MarketWatch. Its Hulbert Ratings tracks investment bulletins that pay a fixed fee to be audited. He can be contacted at [email protected]
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