What We Should Remember About Bear Markets*
* There are many definitions of what makes a Bear Market. Simplistically, a bear market can be seen as a prolonged period of price declines in a stock, index, asset class etc… Sometimes this is viewed specifically as a price decline of 20 percent or more from a recent high. Other than to signal the magnitude of the decline in prices, the moniker has no particular relevance for investors. The opposite of a Bear Market is a Bull Market where prices rise for a prolonged period.
Year to date, the S&P500 Index is down more than 18% to the end of April 2022, and enthusiastic market commentators and daily scribes (even the august Wall Street Journal) are starting to ask if that particular index is heading into a Bear Market.
Bear markets are an inescapable feature of equity investing, and most of our clients’ portfolios which are invested for the long-term have some allocation to equities. Bull markets are also one of the greatest challenges that investors will face. This is not because of the (hopefully temporary) losses that will be suffered, but mainly due to the poor choices we are liable to make during them! If we are to enjoy long-term investment success, we need to be able to navigate these exacting periods.
In a bear market, smart long-term decisions can often look foolish in the short term, whereas in a bull market, foolish long-term decisions can often look smart in the short term.
Here are some features of bear markets that it pays to remember:
They are inevitable: Bear markets are an ingrained aspect of equity investing. We know that they will happen; we just cannot know when or why. That they occur should not be a surprise.
They will feel predictable (in hindsight): As share prices fall, hindsight bias will run amok. It will seem obvious that this environment was coming – the warning signs were everywhere.
Our time horizons will contract: Bear markets induce panic, which means our time horizons shorten dramatically. We stop worrying about the value of our portfolio in decades and start thinking about them in minutes.
Emotions will dominate: Our ability to make good, long-term decisions during a bear market is severely compromised. Rational thought will be overcome by the emotional strains we are likely to feel – what happens if things keep getting worse and I didn’t do anything about it?
We will extrapolate: During a bear market, it is hard to see anything ahead but unremitting negativity. Our tendency will be to believe that things will keep getting worse – prices will be lower again tomorrow.
Bear markets are the ultimate behavioural test: The outcomes of bear markets are more about ourselves than they are about the market. Investors entering a bear market with identical portfolios can have wildly different results based on the decisions that they make during it.
We won’t consider what a bear market really means: In the near-term, bear markets are about painful and worry-inducing portfolio drawdowns, but what they really are is a repricing of the long-run cash flows generated by a business / the market. The underlying value of those businesses doesn’t change anywhere near as much as short-term market pricing does.
Lower prices are good for long-term investors: For younger investors saving for the long-term, lower market prices are attractive and beneficial to long-run outcomes (it just won’t feel like it).
Each bear market will be different: We should ignore all charts comparing current declines with other bear markets in history, they are entirely unhelpful. There is no reason to believe that such a deeply complex, unpredictable system should mimic patterns of the past. Each bear market is unhappy in its own way.
Nobody will call the bottom: Market timing is impossible, and this fact does not change during a bear market. The only difference is the attraction of attempting it when portfolio values are falling can become overwhelming, and the damage it inflicts will likely be greater than usual.
What we should remember about Bear Markets
Equity bear markets make all the usual challenges of being a long-term investor that much more difficult. The noise of daily market fluctuations can become deafening, you may check your portfolios even more frequently and you may find that the urge to make short-term trades becomes nearly irresistible.
It is during these times, which see prolonged declines in asset prices, that systematic decision making – such as maintaining diversification, rebalancing and continuing with regular saving – come to the fore. Realising that our behaviour in these markets can be the biggest determinant of how we emerge from them can mean the difference between locking in permanent capital losses and emerging strong on the other side.
If you are worrying about markets right now, give us a call and chat with us. We would love to hear from you.
This post has been edited and adapted from a recent post (thanks Joe!) at behaviouralinvestment.com.