Are you ready for the next bear market?
You promised yourself you would never go through another 2008 without being prepared. “Never again” you said as the market rebounded off the bear market lows and your portfolio clawed its way back from a 50% drawdown. “I went through this in 2000 and then again in ’08. Next time, I’m going to be ready and protected.”
Next time might be now.
So have you prepared? Have you kept your promise? Are you about to find out?
The recent resurgence in volatility may have you asking yourself similar questions. It comes after a record-setting period of smooth sailing for U.S. stocks, a correction-free market environment when every dip was reversed before you had the chance to make it back from Starbucks (SBUX).
Sure, we had gotten close to a 10% correction in the S&P 500 in recent years. The 2013 “taper tantrum” drove the index down about 7% before the Fed spun into damage control from its earlier statements. The October 2014 dip was a closer call, with the large-cap index dropping some 9% as ISIS rampaged its way across Iraq and every sneezing airline passenger portended a domestic Ebola epidemic. As those fears subsided, the index once again recovered and climbed to all-time highs. Crisis averted.
But August’s tumble finally took the index past that psychologically important 10% mark, and in late September, after a partial rebound in stocks, it crossed the line again. Investors are struggling with a nagging feeling that something is fundamentally amiss. This uneasiness shows up in all the sentiment surveys: The invincibility we felt when the Federal Reserve was drowning the investment markets in billions of dollars’ worth of buying power each month is gone. We’re not quite jumping into the pool feet first the way we once were.
In the absence of this gusto, a new sense of uncertainty has crept in. As J.R.R. Tolkien’s elfin sorceress Galadriel intoned, “The world is changed. I feel it in the water. I feel it in the earth. I smell it in the air. Much that once was is lost.”
There are lots of reasons for investors to feel that something is off. China’s economy and stock market are in their worst shape since the global recovery began. Brazil is in even worse shape, with a looming budget disaster and the ongoing commodity crash pushing its stock market to within 10% of its lows from the great financial crisis. Europe’s economic malaise is unresolved, and the Middle East is, well, being the Middle East. And then there is the ongoing fear about the future course and timing of interest rate hikes.
A more recent fear that has been driven to the fore revolves around market structure and the lack of confidence that the system will be able to hold up under duress. U.S. mutual funds and ETFs currently hold $18 trillion of investors’ capital, and, to paraphrase Jack Bogle, if everyone wants his money back at once, it’s not going to happen. We recently got a little taste of what something like that could look like. On Aug. 24, a combination of retail investor redemptions, exacerbated by algorithmic (read: non-sentient) trading, pushed the Dow Jones industrial average down more than 1,000 points within minutes of the market open.
More than 1,200 individual stocks were halted on the NYSE that morning under a circuit-breaker rule that was created to stop declines from becoming full-blown panics. Exchange-traded funds, which typically hew fairly closely to the value of their underlying holdings, became utterly divorced from reality as a result of these circuit breakers, with several popular ETFs “gapping down” to trade at 20% to 40% lower than the value of their underlying assets.
Although these dislocations were rectified in short order that day, they’ve made an indelible impression on retail investors. The ubiquitous complaints from professionals about the dangers of fading market liquidity are resonating with the general public now that they’ve seen a flesh-and-blood example.
Approximately 56% of the U.S. mutual fund industry’s assets are in the stock market, with another 22% invested in bonds. Investors in these products have not panicked yet; they are holding on but gritting their teeth. For U.S. stock funds, outflows for the month of August totaled a net $5.9 billion. That’s a relatively small number when compared with the $9.6 billion investors ripped out in July, or the gigantic outflow of almost $26 billion back in April. In other words, with very little net selling by mutual fund and ETF shareholders, we still managed to see quite a bit of discombobulation in the marketplace.
The lingering question is, What happens when it gets real? Very few of the most vocal market commentators believe that the system can withstand a real risk-off moment when investors bail out of stocks en masse. You’re forgiven for watching the day-to-day market proceedings from the edge of your seat. It’s completely understandable.
Let’s get back to that promise you made to yourself—the one about being prepared for the next bear market or economic conundrum. At my wealth management firm, we approach these types of concerns by addressing them in the context of our clients’ individual financial plans. Here are some of the specific questions we find ourselves dealing with in an environment like this one.
Am I overexposed to the stock market? There is a feature of the investment markets known as the equity risk premium. Equities have been able to deliver an inflation-adjusted annual return above the return of the risk-free rate (the return on short-term Treasury bills) that is somewhere around 5%. This higher rate of return makes a big difference over years and decades as it compounds your wealth, but it comes at a price. You aren’t awarded this premium just for waking up in the morning; you have to earn it. You earn it by balancing all the short-term negativity against your awareness of your own long-term-return needs.
These days we’re asking more from our portfolios than ever before. Retirements are becoming a multidecade affair for a large portion of the population as we age more gracefully and live longer, more active lives. Unfortunately, these extra years of living (and spending) demand a higher tolerance for the variability and volatility of equity returns. To determine whether you’re too exposed to stocks, the first step is identifying what you need to get from your portfolio and for how long. This is equal parts art and science, with a bit of psychology thrown into the mix as well.
There are two very important things about stock investing that most people forget when turmoil shows up. The first is that expected future returns are rising when the market is falling. The second is that preserving the nominal amount of dollars you currently hold will not fund a retirement; only the preservation of purchasing power will. For this reason you’re actually taking a bigger risk by not maintaining equity exposure.
What about interest rate risk? Bond market risk is a puppy dog compared with the uncaged tiger that is the stock market. A bad year for a diversified portfolio of investment-grade bonds looks like a mid-single-digit loss, as opposed to the average annual decline of 14% that the S&P 500 suffers in a down year. Rising interest rates pose a risk for bond investors because when newer bonds are issued with higher coupons, the value of existing bonds with lower coupons declines as investors trade up. Fixed-income securities that are paying out at a lower interest rate than the prevailing interest rate of the day find themselves under pressure.
That’s why a well-constructed bond portfolio is typically “laddered,” with a range of bonds maturing at staggered intervals so that, as lower-yielding bonds mature, newer bonds with higher yields can be purchased, locking in ever higher coupons for the future. This gives a portfolio a built-in defense mechanism against a gradually rising interest rate, which is precisely what the Federal Reserve has in mind right now. The balance of risk, globally speaking, is weighted toward deflation as opposed to inflation, which means the Fed has no need to hurry the pace of interest rate increases anytime soon. In this context, for investors, slowly rising rates represent more of a silver lining than they do a serious threat.
Should I be hedging more? It’s possible that you’ve gotten serious about hedging against some of the epic volatility that was keeping you up at night between 2008 and 2011. But not all hedges are created equal, and some work only periodically. Some hedges are not hedges at all; rather, they are merely a different set of risks in disguise. Other hedges fail you at the very moment you need them most. Still other forms of hedging can be so incredibly expensive or impractical that they actually end up being a cost for you over the course of a full cycle.
Hedge funds, “black swan” funds, bearish options strategies, managed futures funds, gold and gold mining stocks, unconstrained bond funds, market-timing services, and volatility arbitrage vehicles have all contributed to investor frustration during the post-crisis recovery. While they should not be expected to compare favorably with a bull market, the magnitude of their underperformance sets up a very high hurdle for the next bear market: Many of them have inflicted so much damage on investor portfolios that it would be impossible to earn their keep no matter how severe the next downturn becomes. The most crucial thing to understand about hedges is that their cost to the long-term investor is not always worth bearing. There are some risks in this world that are worse than volatility.
What if stocks and bonds sell off at the same time? The nightmare scenario for the investor who has prudently divided up her assets among stocks and bonds is sitting by helplessly as they both sell off at the same time. This situation would temporarily negate the benefits of diversification and rebalancing. And right now, with both bonds and stocks selling at historically high valuations, this is a distinct possibility.
In fact, it’s happened before, although only very rarely. In just three of the past 88 years, bonds and stocks have had negative returns at the same time (1931, 1941, and 1969). In those three years, investors lost money in both the S&P 500 and the 10-year Treasury note. In other words, during just 3.4% of all annual periods for which we have reliable data, a diversified portfolio didn’t work. To which the rational person would say, “So what.” Considering that you are most likely investing for a period of greater than one year, this is a potential risk that is not worth obsessing over.
Investors should not expect their bond portfolios to protect them from every bad month in the stock market. The benefits of diversification among the two asset classes typically take between one to three years to show up. Consider that the monthly return for a portfolio of government and corporate bonds is actually much lower on average during a month when stocks fall. This is highly counterintuitive, but it doesn’t really matter when looking at the longer term. The fact is that this same portfolio of bonds has returned an average of 7.9% for all rolling three-year periods during which stocks have fallen by 10% to 20%. These are the times when the diversification benefit truly shines through.
You might be feeling more consternation about your portfolio this fall than you’ve felt for a while, now that the gains are not coming automatically anymore. This is entirely natural, and it’s nothing to be ashamed about. The good news is that, historically, a crisis rarely materializes when nervousness is already so widespread. Investors aren’t bidding up valuations to reckless levels or completely disregarding the risks. In this way fear keeps markets at a more reasonable level and acts as a governor of sorts, keeping us all in check.
Should this summer’s volatility persist, it would help to remind yourself that every day you endure it, you are earning the premium long-term returns that not all investors have the stomach for. That makes you the winner of a game that many others consistently lose.
For more on the Chinese stock market, watch this Fortune video:
This is an updated version of an article that appears in the October 1, 2015 issue of Fortune magazine.