How to prepare for a bear market

In a perverse way, the stock market correction we’ve experienced this past few months is a welcome relief. OK, no one likes watching their portfolio fall in value, but we really did need a wake-up call. Over the previous couple of years I’d heard from countless investors who seemed to have forgotten that stocks can actually go down.

The complacency was understandable. When the S&P/TSX Composite Index dipped about 10% in the six weeks following Labour Day, it was the first correction in Canadian stocks since 2011. Meanwhile, the slump in U.S. equities erased virtually all the gains they had made since January and it looked for a while like this might be the first down year for the S&P 500 since 2008.

It’s during periods of market turmoil that investors really prove their mettle, because that’s when you’ll be tempted to abandon your long-term strategy. And at some point (know one knows when) a full-blown bear market will arrive. Whenever that happens the media will respond with alarmist nonsense and terrible investment advice. Here’s what you can expect to hear if markets keep heading south.

“Indexing doesn’t work in a bear market.” From the market bottom in March 2009 to the end of September this year, the humble Global Couch Potato portfolio returned well over 10% annualized. When markets are exceptionally kind like this, it’s even more difficult for active fund managers to beat their index benchmarks. However, when stocks go through a rough patch, active managers can get defensive by moving to cash, high-quality bonds or other protective positions and slow the bleeding. That’s why critics often say indexing stops working in bear markets.

It’s true that during some periods of market stress, a majority of active funds have outperformed the indexes. And overall, the relative performance of active funds is generally better during bear markets than in more prosperous times. But getting defensive is a double-edged sword: often it leaves investors sitting in cash when markets move up rapidly and unexpectedly—which is what usually happens in a recovery. Over an investing lifetime, the odds of beating the market by reliably anticipating bear markets are vanishingly low.

“We saw it coming.” With every big move in the markets there’s a gaggle of gurus claiming they predicted it. But market predictions are useless unless the timing is accurate, so anyone who was forecasting a downturn for months can’t take credit for a good call. A weather reporter who tells you to carry an umbrella for nine sunny days in a row doesn’t get to gloat when it finally rains on the 10th day.

The evidence is clear that no one can time the market reliably, and those who are successful are usually just lucky. Financial history books are filled with “geniuses” whose one good call was followed by a series of boneheaded ones.

Let’s remember that commentators have been predicting a significant pullback since late 2012, and some Chicken Littles have made their careers repeating their gloomy forecasts over and over. Others have inaccurately forecasted interest rate hikes for years—and they’ll crow about their shrewd call if and when that finally happens. Meanwhile, investors who sat in cash waiting for either of these predictions to come true paid an enormous opportunity cost.

“You can’t just sit there and do nothing.” One of the most difficult behavioural hurdles for investors is what psychologists call action bias. We’re wired to think that doing something is better than doing nothing, even when that something is counterproductive. And for some reason, many investors think that sticking to a long-term strategy is “doing nothing.” This tendency increases during periods of market turmoil, when Couch Potatoes are mocked for being naive: “Sure, just keep holding those index funds while the economy is crumbling. Let’s see how that works out for you.” Savvy investors, the logic goes, don’t twiddle their thumbs: instead, they reposition their portfolio for what’s ahead.

This sounds compelling, but once again the evidence suggests your best course of action is to simply adhere to your plan. As the Nobel laureate Daniel Kahneman writes in his book, Thinki
ng, Fast and Slow: “It’s clear that for the large majority of individual investors, taking a shower and doing nothing would have been a better policy than implementing the ideas that came to their minds.”

If you can’t resist making changes these days, there’s one useful way to channel that urge: rebalance your portfolio. If you have a target asset mix of half stocks and half bonds, for example, chances are recent events have left you underweight in the former and overweight in the latter. If so, you can add new money to your equity holdings, or even sell some bonds and use the proceeds to top up your stocks. That’s probably the opposite of what your gut is telling you (not to mention what the financial media and many advisers are telling you), but it’s the winning formula.

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Dan Bortolotti is an investment adviser with PWL Capital in Toronto. His Canadian Couch Potato blog can be found at MoneySense.ca