25 April 2024

Why Bear Markets Are Inevitable

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It has been more than seven years since the last bear market began. Stock markets always will—indeed, must—crash from time to time. To see why, consider the work of the late economist Hyman Minsky. In the 1970s, most theories held that modern economies were fundamentally stable. Deep recessions and financial crises were anomalies, caused by outside “shocks” such as bad policy, war or a spike in oil prices. Mr. Minsky didn’t buy this. Mr. Minsky believed that a stable economy leads to optimism, optimism leads to excessive risk-taking, and excessive risk-taking leads to instability. The process continues until optimistic bankers lend to dubious borrowers who stand no chance of repaying their debts. That is when the next crisis begins.

The paradox of investing is that if markets never crashed—or if investors gain the perception that they never crash—stock prices would rise so high that a new crash becomes nearly certain.  Rather than wondering if another bear market will occur—it will—here are three things investors should do:

Realize what you are getting into. 

The reason stocks have historically returned more than cash or bonds is specifically because they are volatile, and crash on occasion. Big volatility doesn’t indicate the market is broken, or that you have been cheated. It is the price of admission investors must be willing to pay to achieve returns greater than is offered in less volatile assets.

Assess how much risk you are willing to take. 

Not everyone can handle the stock market’s inevitable swings, especially if you are in, or nearing, retirement. Balancing a stock portfolio with bonds can help reduce volatility while still letting you earn a decent return.

The Vanguard Balanced Index Fund holds 60% of its assets in a broad basket of U.S. stocks and 40% in a diversified portfolio of U.S. bonds. The fund returned an average of 6.95% a year for the 10 years ended Dec. 31, 2014, according to Vanguard, while the S&P 500 returned 7.7% annually, according to data from investment-research firm Morningstar.

The fund lost 36% during the last bear market—from Oct. 9, 2007, to March 9, 2009—compared with a 55% loss for the S&P 500. It charges annual expenses of 0.24%, or $24 per $10,000 invested.

Learn from your past behavior. 

Rather than trying to estimate how you will react to a big market drop in the future, assess how you reacted in the past. Past behavior can be a good indicator of future behavior.

Did you panic and sell when stocks crashed in 2008 and 2009? Then you probably have a low risk tolerance, regardless of how confident you feel today. Consider cutting your stock exposure to something less than you had before the last market crash and raising your allocation to a diverse portfolio of bonds, or even cash, taking comfort that more of your money is now cushioned against the inevitable shocks of the stock market.

Click here to access the full article on The Wall Street Journal. 

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