Is a Bear on the Prowl in the Stock Market?

As investment managers, it is common for friends, acquaintances, and sometimes clients to ask us where we think the market is headed. Another question we are asked is whether or not we are in a bull or bear market. The bear market question is usually asked after the market experiences a sharp drop, like it did at the beginning of 2016. Unfortunately it seems some people believe that having a strong opinion on the short-term direction of the stock market is a prerequisite for being an investment manager. I sometimes receive bewildered looks from those asking these questions because my typical response is something along the lines of: “I have no idea.”

The Wall Street Journal recently posted an article online originally published in March 2015. Entitled How to Survive a Bear Market, it touches on the issue of what an investor should do if he or she believes a drop in the stock market is inevitable. The essence of the article is that because people are quite bad at predicting the direction of the stock market, investors who sell in anticipation of declines (or vice versa) almost always do worse than if they’d just sat still and stuck to their original plan. The article cites some compelling research about the returns of the average investor in equity mutual funds:

“The average investors in stock mutual funds made 3.8% a year over the past 30 years according to Boston research firm Dalbar Inc. That is one-third of the S&P 500’s average 11.1% gain in that period. Dalbar’s explanation for this sad performance: People buy and sell funds at all the wrong times.”

Compounded over a number of years, the results of this underperformance could mean the difference between a fully funded retirement versus a painful shortfall: a $250,000 portfolio compounded over 15 years at 3.8% versus 11.1% results in ending values of $437,000 and $1.2 million, respectively. The primary reason for this dreadful performance differential is that the average investor sells after the market has already fallen and then buys after the market has risen and stocks seem “safe” again. Buying high and selling low is a great recipe for significantly below-average returns. At the same time, even if someone is able to sell prior to a steep drop, it can be very difficult to know when to get back in. No one rings a bell at the bottom. For the investor who misses the rebound, he simply ends up where he started and forfeits the opportunity to accumulate stocks at bargain prices. In addition to poor performance, there are other potential negative consequences to unnecessary trading including incurring excessive fees and/or taxes.

Instead of asking where the market is headed, the article recommends investors ask themselves when they will need the money. For investors in or near retirement (i.e. those who currently or will soon begin taking distributions from their nest egg), having the right asset allocation regardless of the future direction of the market is of paramount importance. The time to prepare for the wide range of potential market outcomes is now, not after the market has already declined. For investors having a long-term horizon, especially those who are regularly adding to investment accounts such as 401-(k)s, a bear market should be welcomed as an opportunity to buy at a discount. For some reason, everyone loves a discount except when it comes to buying stocks. Logic and market history tell us that the lower the starting price, the higher the subsequent long-term returns, and vice versa. Looking back over the past decade, by far the best time to buy stocks was in late 2008 and early 2009 when prices had crashed. For investors who regularly added to their investments throughout this period, they are better off today compared to if the market had not crashed. Obviously this is easier said than done.

The idea of selling at the peak and getting back in at the bottom is so appealing because it is it potentially so lucrative. However, for most investors this notion is a pipe dream and potentially a very costly mistake. We don’t try to determine our buying and selling based on what we believe the market will do. As investment managers, we focus on making sure our clients have appropriate asset allocations given their specific circumstances and we try to be prepared to take advantage of opportunities offered by market declines. In fact, we increased some of our existing stock positions early in 2016. We believe that focusing on these goals and remaining calm in the face of volatile markets is a much better service to our clients than buying and selling based on short-term market expectations.

[1] http://www.wsj.com/articles/how-to-prepare-for-a-bear-market-in-stocks-1425870192