Opinion: Stock investors can no longer ignore the next bear market

By Mark Hulbert, Columnist
Published by MarketWatch: Oct 1, 2018

Opinion: Stock investors can no longer ignore the next bear market
The biggest obstacle to long-term investment success is “the dogma that you must beat the S&P 500 during bull markets.”

So writes Brian Livingston in his new book “Muscular Portfolios: The Investing Revolution for Superior Returns with Lower Risk.” I couldn’t agree more.

Livingston is an investigative journalist who has focused his energies in recent years on the investment industry. He is president of the Seattle chapter of the American Association of Individual Investors, and I think highly of both him and his work. (For the record, I have spoken to that AAII chapter, but I have no financial interest in his book sales.)

Big losses require even bigger gains to recover.

Livingston’s insight is that beating the S&P 500 SPX, -0.15% during bear markets is far more important than during bull markets, for two reasons. The first is mathematical: Big losses require even bigger gains to recover, and at some point the required gains become so large as to become improbable. So if you lag during bear markets you have to beat the S&P 500 by a lot during bull markets to come out ahead over the long term.

To illustrate, consider the investment newsletter among the several hundred monitored by my Hulbert Financial Digest that lost the most — 79% — during the bear market from October 2007 to March 2009. (Out of charity I won’t mention its name.) Care to guess what its gain since March 2009 would have to be in order to merely equal the S&P 500’s return over the entire period since October 2007? More than 1,000%. (It has not come close, needless to say.)

To put that in context, you should know that the S&P 500’s return since March 2009 has been “just” 380%. In other words, this huge bear-market loser would have had to beat the subsequent bull market by nearly three to one just to equal the S&P 500’s return over the entire bull-and-bear cycle. That’s an almost-impossibly high hurdle.

The second reason why it’s more important to limit bear market losses is behavioral: It’s the rare investor who can tolerate big bear market losses. All too often, investors end up throwing in the towel during the latter stages of a bear market and so miss out when the market recovers.

What is the threshold beyond which the typical investor is unwilling to tolerate a loss? Livingston quotes Ben Carlson, director of institutional asset management at Ritholtz Wealth Management: “In a 10% correction, people for the most part are OK. At 20%, people get a little edgy. When you get to the 30%, 40% loss range, people say, ‘Get me out. I tap out. That’s it’.”

As a reminder, the average stock lost 49% in the 2000-2002 bear market (even after including dividends), and fell 55% in the 2007-2009 bar market.

There’s also a psychological explanation for the phenomenon to which Livingston is referring: The all-too-human desire for excitement. Not losing as much as the S&P 500 during a bear market is not as exhilarating or motivating as making more money than the index when the market is rising. To use a baseball analogy, we’d rather hit a grand slam than avoid a strike out and earn a walk to first base.

The investment implication is that financial advisers and investors alike should be focusing more of their energies on how to limit bear market losses than on how to beat the S&P 500 during a bull market. Nowadays, with the U.S. stock market at an all-time high, is the perfect time to do so. It will be too late if you wait until we’re in a bear market.

The urgency of Livingston’s advice is apparent upon review of the percentage of IRA accounts that are allocated to equities. As of the end of 2016 (the latest year for which Investment Company Institute data are available), those aged 70 and higher were allocating an average of 61.5% of their IRAs to equities. It’s a good bet that this equity allocation is far higher than what most retirees can tolerate through a bear market.

Look at what happened in the 2008-09 financial crisis. The comparable IRA equity allocation at the top of the market in 2007 was almost as high as it is now, as you can see from the accompanying chart. By December 2008, two months before the bear market would finally end, that allocation had dropped to 46.6%.

Margaret Leto November 14th, 2018

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