We’ve just been through the worst week in the stock market since darkest days of the financial crisis in October 2008. The speed with which markets have plunged in response to the coronavirus outbreak has been enough to test the nerves of even the most stoic investor.
While this correction has been particularly brutal, market declines are a normal part of investing. That’s why we prepare for them when the markets are climbing higher.
Over the last decade, investors have enjoyed a bull market that produced annualized gains of 16% from the U.S. stock market and 6.9% in Canada. At many points during those 10 years, market gurus have wrongly predicted the start of the next bear market. Has it begun now? Or will the markets quickly snap back and reach new heights? It’s impossible to know.
No one can predict the timing, length or severity of the next bear market, defined as an extended price decline of 20% or more following a stock market peak.
In 2018, I compiled statistics on bull and bear markets. Looking back at past market cycles since 1970, the average bull market in the U.S. lasted 9½ years (113 months), compared to more than 2½ (33 months) for the average bear market. In Canada, the cycle was shorter, with the average bull market lasting 63 months and the average bear market lasting 11 months.
Gains during bull markets far surpass losses during bear markets. However, we know from the work of behavioral economists Daniel Kahneman and Amos Tversky that humans are hard-wired to be loss averse. We feel the pain of losses more intensely than the joy of wins.
And that’s why market downturns can be so dangerous. Despite good intentions, losses can wear on investors and lead them to make decisions that end up derailing their financial plan.
The reality for most people is that to achieve their financial goals, they will need to be invested in the stock market for decades and that means experiencing many market cycles, including several bear markets.
The best way to make this journey successfully is through careful portfolio design and a discipline approach to investing. Every PWL client has a personal investment policy statement establishing how much risk they’re willing to take by setting a target asset allocation. As part of that allocation, all portfolios include a portion in fixed income to reduce volatility at times like this. Portfolios are globally diversified, holding thousands of securities across all market sectors.
Another part of our discipline in managing portfolios is rebalancing. It involves buying or selling securities to return portfolios to their target asset allocations after market fluctuations. Accordingly, profits were realized in stocks all along the rise of the market in the last decade. Conversely, when market declines brings the equity allocations to an underweight position, we sell some bonds to buy stocks at discount prices and return to target allocation.
