History shows that the biggest risk is not being in the market when it drops, but being out when it rises which can often be referred to as a risky investor behavior especially when such an investor has no clear cut investment strategy. Investing for retirement usually means placing at least a portion of your money in the stock market. The reason is that, over long periods of time, it is highly probable that the returns from stocks will exceed the returns from most other asset classes, such as bonds and money market funds. In addition, stocks provide a hedge against the erosion of principal caused by influence and taxes.
The extra gain expected from stocks is not without extra risk. There have been several periods when the market fell 20% or more in a short time and other periods when stocks is not outperform bonds or money market funds for a long time. When a deep bear market rolls around, it is often a brutal test of an investor’s nerves. Bear markets can be painful emotionally and financially.
Individual investors have no control over the direction of the market. The only decision is to be in or out. When you are in and the stocks fall, you lose money. When you are out and stock rally, you miss an opportunity. But losing money is only one of the issues. Bear markets can cause anxiety, frustration, sleepless night, a feeling of hopelessness, and all kinds of uncomfortable side effects.
Due to all the bad stuff a bear market can cause, wouldn’t it be wise to find a market expert who will magically get you out of bad markets and into good ones? That is a nice dream, but it is not reality. Market timing does not work. No one can predict the direction of the stock market with enough accuracy to make any money – and if they could, why should they sell their alchemy services to you?
Instead of trying to predict bear markets, investors should simply be prepared for them. Successful investing hinges on the development of a diversified portfolio using an appropriate mix of low cost mutual funds. This portfolio should include U.S. stock funds foreign stock funds, bond funds, and real estate funds. A diversified portfolio significantly reduces the impact of a bear market on your portfolio, saving you money and makings you feel better as well. This chapter provides a brief overview of diversification techniques.
Bear markets should only be a minor nuisance in your life and should have no effect on your retirement savings plan or your ability to sleep at night. They occur as a normal part of the economic cycle in every free-market economy and are a natural part of economic growth. If you live to be in your 80s or order, there is a good chance you will be involved in at least two lengthy bear markets during your life and many more short-term market corrections.
Bear Markets Occur More Often Than We Think
When the stock market falls a lot, the mass media tends to talk about the decline like it is the end of the capitalistic system in America. Nearly every newspaper in the country prints a picture of some humbled trader on the floor of the stock exchange, hands holding his head, in complete, utter shock. The caption below the picture reads “Sell, Sell, Sell!” or “Market Breaks Support” or “Panic on Wall Street”.
(I think it is funny to note that most newspaper editors cannot tell the difference between a trade on the floor of the stock exchange and a trader in that commodity pits in Chicago. When they pick a file photo of a “depressed stock trader” for the newspaper, many times it is actually a picture of a commodities trader who has had a bad trading pork bellies.)
News about movement in the market is so editorialized that, depending on which news show you watch or which newspaper you read, the reasons given for the market decline could be vastly different. A Los Angels newspaper may report the market is down due to higher interest rates while a Chicago paper reports the market is down due to profit taking and Boston paper reports the market is down due to poor earnings. Who is right? Who is wrong? Who knows?
The fact is that the market is down because there were more sellers than buyers, at least on that day. One day in July 2001, the wall street journal actually reported, “with many traders on vacation, the market barely budged. “ it is amazing what passes for news.
A market decline of 10% to 20% is known as a correction. Since Wall Street is paid to be bullish on stocks, the word “correction” is a nice replacement for the words “lost money”. When Wall Street firms say the market is “in a correction”, it is supposed to make you feel better about losing money because it implies the market is setting up for bigger gains in the future. Correction occur on average every two years and generally coincide with some potentially harmful economic or global event, like Russia defaulting on its debts in 1998.
A bear market is a correction of 20% or more. It is widely believed that bear markets coincide with economic recessions. This means lower sales at retail stores and higher unemployment. And sometimes it does not. It did not in 1987, but it did in 2000. Economic data is always behind actual economic conditions, so we never know if the market is telling the truth. A standing joke on wall street is that the stock market forecast eight out of the last three recessions.
The following tables provide some interesting stock market data on negative years, market corrections, and bear markets in the U.S. the lesson to learn from this data is that bad market conditions occur more frequently than we think.