Bear Markets: A Necessary Evil

“Bear markets are the mechanism that serves to transfer assets from those with weak stomachs and without investment plans to those with well-thought-out plans—with the anticipation of bear markets built into the plans—and the discipline to adhere to those plans.” – Larry Swedroe.

The author of The Only Guide to a Winning Investment Strategy You’ll Ever Need: The Way Smart Money Preserves Wealth Today, Larry Swedroe always writes clearly and succinctly, and he conveys a great deal of information in a short time. 

This post is a summary of his excellent column Bear Markets: A Necessary Evil.  It is the best article I have read on investing strategy in general and during a Bear Market, in particular.

If you are a serious student of investing, I highly, highly recommend that you read the entire article, which obviously has more detail than this summary.

A necessary evil can be defined as an unpleasant necessity; something that is unpleasant or undesirable but is needed to achieve a result. An example of a necessary evil might be taxes. Investors should also view bear markets as a necessary evil.

His key point is important, but subtle:

Perhaps the most basic principle of modern financial theory is that risk and expected return are related. We know that stocks are riskier than one-month Treasury bills (which is considered the benchmark riskless instrument). Since they are riskier, the only logical explanation for investing in stocks is that they must provide a higher expected return. However, if stocks always provided higher returns than one-month Treasury bills (the expected always occurred) investing in stocks would not entail any risk—and there would be no risk premium.

Bear markets are necessary to the creation of the large equity risk premium we have experienced. Thus, if investors want stocks to provide high expected returns, bear markets, while painful to endure, should be considered a necessary evil.

Risk Premiums and Investment Discipline

“The bottom line is that the outperformance of stocks relative to Treasury bills” entails risk.

And it is a virtual certainty that the risks will show up from time to time. Unfortunately, we cannot know when, or for how long, the periods of underperformance will last, nor how severe they will be.

It is during the periods of underperformance when investor discipline is tested. Unfortunately, the evidence suggests that most investors significantly underperform both the stock market and the very mutual funds in which they invest.

The reason for the underperformance is that investors act like generals fighting the last war. They observe yesterday’s winners and jump on the bandwagon— buying high—and they observe yesterday’s losers and abandon ship—selling low.

Why most investors fail

1. Investors allow their emotions to impact their investment decisions. In bull markets, greed and envy take over and risk is overlooked. In bear markets, fear and panic take over, and even the well-thought-out plans can end up in the trash heap of emotions.

2. Investors are overconfident of their ability to deal with risk when it inevitably shows up.

3. Investors often treat the likely (stocks will outperform Treasury bills) as certain and the unlikely (a severe bear market) as impossible. The result is that they take more risk than is appropriate—and when the risks show up they are “forced” to sell.

The Keys to Successful Investing

1. The first key to successful investing is to have a well-thought-out plan. That plan includes an understanding of the nature of the risks of investing. That means accepting that bear markets are inevitable and must be built into the plan.

2. Those investors that avoid excessive risk taking are the ones most likely to be able to stay the course and avoid the buy high/sell low pattern that bedevils most investors.

3. Understand that trying to time the market is a loser’s game. A loser’s game is one that while it is possible to win, the odds of doing so are so low that it is not prudent to try.

Summary

It is difficult for most individuals to control their emotions—emotions of greed and envy in bull markets and fear and panic in bear markets.

Bear markets are a necessary evil in that their existence is the very reason that the stock market has provided the large risk premium and the high return that investors have had the opportunity to earn.

But there is another important point that investors need to understand about bear markets. Investors in the accumulation phase of their investment careers should actually view bear markets not just as a necessary evil, but also as a good thing. The reason is that bear markets provide those investors (at least those that have the discipline to adhere to their plan) with the opportunity to buy stocks at lower prices, increasing expected returns.

It is only those that are in the withdrawal phase (e.g., retirees) that should fear bear markets. The reason is that withdrawals make it more difficult to maintain the portfolio’s value over the long term. Thus, investors in the withdrawal phase have a lesser ability to take risk and should build that into their plan.

The bottom line for investors is this: If you don’t have a plan, immediately sit down and develop one. Make sure the plan anticipates bear markets and outlines what actions you will take when they occur (doing so when you are not under the stress that bear markets create).

To repeat, this entire post is a summary of Larry Swedroe’s article.

The words are his; I just happen to agree with them wholeheartedly.