Preparing for the Next Bear Market

Are You and Your Investments Ready for the Next Bear Market?
The single most important question to ask yourself (and your financial advisor)

Well, the stock and bond markets are behaving themselves rather nicely. In fact, the financial markets in general have provided some nice returns for investors the past couple of years. Sure, there have been setbacks and some hiccups along the way; no market goes straight up for very long! In fact, the stock market has evidenced pullbacks ranging from 7% to 18% since early 2010. I will call those periods "corrections" within a bull market.

 I feel that we have been lulled into our current optimistic thinking because of the brevity of any of these 6 corrections. I state this because in the past three years, it's been just a couple weeks or at most - less than a full quarter (3 months) in which stock prices fell before then recovering and rising again. So, if you receive your statements in the mail quarterly, then you probably wouldn't notice these small downturns - even monthly it may not jump off the page at you. But they are important, since the stock market does not operate according to any man-made calendar, and a prolonged downturn in stock prices will occur - we just don't know when. The terrible 50% losses in the 2007-2009 bear market are now distant memories - but there's danger in not learning a lesson from that history; and we're no smarter if we don't learn from past mistakes and errors, agreed?

You and your advisor should understand the financial concept that I have described above. It has a name: it's called drawdown - and it is very important. It's all about inherent risks, and the behavior of your portfolio through the tough times when stock prices are falling. Since your portfolio will hold various stocks, mutual funds, bonds and perhaps cash, commodities, each category will behave differently. But your overall portfolio will have a "number" that represents its volatility versus the stock market. Without turning on more technical speak, your drawdown number is the maximum loss of value to your portfolios, measured in percent or dollars.

We'll use four main categories of assets that your could own, and that I advocate to build a diversified portfolio. Drawdown is represented as a percentage of your account value from the high point reached on any one day, so I will use a real world example here to illustrate, using the last nasty bear market in stocks as our test period: October 2007 to March 2009. Here are the results:

100% stocks (represented by the S&P 500 stock index): a drawdown of 54% (loss)
50% stocks / 50% bonds (represented by long term Treasury bonds); a drawdown of 19% (loss)
One-third of your portfolio is stocks, bonds and GOLD; a drawdown of 19% (loss)
Four way split: stocks, bonds, gold and cash money fund: a drawdown of 14% (loss)

So, you may be thinking now, and questioning - "it appears better to diversify because I will reduce my drawdown". That is correct! "But I have still lost lots of money in this bear market, so I'm not happy".

My reply, "No you didn't. At least not entirely!"

Drawdown, and the gains or losses of your portfolio are not the same. They are different, so follow along: to recap - drawdown is the maximum loss to your portfolio if you were to view your portfolio on the worst day during the period (it's one day when you are performing the worst from the beginning point (October, 2007). If you held all stocks (like the S&P 500 stock index), your worst day was March 6th, 2009; a 54% loss, on the last day of the end point. But for Gold, Bond and Cash, the timeframes are different. Understand?

For instance, gold increased $200 an ounce in this entire time span, but it was not straight up. It declined 30% in one seven month period. Bonds, they declined 20% at one point in time, and ended up losing 8% for the entire period.

Finally, here are the results (gains and losses) for this last bear market in stocks, if you were diversified across the investment categories we reported on above, and your portfolio performed exactly in line with the categories I used:

All stocks: loss of 54% of your money (ouch, that hurts; retirement delayed)!
50 / 50 in stocks and long-term government bonds: a loss of 12% of your money (whew, I can surely recover from that).
One third each in stocks/bonds/gold: a GAIN of less than one percent: (I live to fight another day!)

4-way split: stocks/bonds/gold/cash: a GAIN of 2% for the entire period (when's the next bull market start?)

The mixture of adding these three classes or "categories" to your stocks will GREATLY affect your gains and losses over time and through various market cycles that we're all subject to as investors; both in up markets and down markets. When your portfolio and retirement accounts experience drawdown of 25-30-40 percent, you are very susceptible to making very poor decisions - like selling out near the worst time, and then staying out when the markets start back up.

Finally, the takeaway here is to understand your risks in your portfolio, and to be on the same page with your financial advisor. If that person cannot communicate to you your potential risks with your money (projected drawdown and losses) when the next bear market arrives, then you may be in for some unpleasant surprises to your pocket-book and mental health. What's the maxim: "plan for the best, put prepare for the worst"? What's your plan?

Give a reply or sign up on the right side of the blog page for e-mail alerts to my posts here.

Leave a post or comment if you found this helpful, and share it with others please.

Cordially,

Barry L. Unterbrink

Chartered Retirement Planning Counselor
www.stetsonwealthmanagement.com
www.twitter.com/allthingsmoney

(954) 719-1151