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- Why bear markets are more damaging than you think…
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Dear Reader,
“Buy and hold” drummers insist it is the prudent course.
The stock market always marches higher over time… as if by natural law… or by divine mandate.
Thus you should perpetually “stay invested.”
And in the overall scheme, the advice appears sound advice.
The stock market has always marched higher over time.
Thus “buy and hold” — over hill, over dale, through bush, through brier — is the everlasting way to wealth.
The “Buy and Hold” Pitch
Typical of the buy and hold doctrine is financial commentator Ben Carlson. From whom:
- In the long term, bull markets versus bear markets are asymmetric. Things are not balanced…
- The bear markets are blips… the bull markets completely overwhelm the bear markets. It’s not even close.
- That’s the beauty of the stock market. Despite all of the lousy things that can and will happen at times, it still pays to stay invested over the long haul.
Just so. Yet therein lies a vast tale.
What if you cannot endure the long haul? What if you are of advancing or advanced years — and a market collapse cleans you out?
You may very well be beyond the rainbow by the time the stock market makes your losses good.
The “Illusion of Safety”
As Mr. Lance Roberts of Real Investment Advice illustrates…
The apparent triumph of bull market over bear market has manufactured an “illusion of safety”:
- Assuming that “bull markets” have dwarfed “bear markets” throughout history creates an “illusion of safety.” This is why such mainstream and mundane analysis is only used to deter concerns about market downturns and suggest that investors remain fully invested at all times.
Yet why, Mr. Roberts, does “buy and hold” hold out the mere illusion of safety?
Why not actual safety?
- Bear market losses, when displayed in percentages, obscure what it takes to recover. Furthermore, it ignores the most critical commodity of all investors: the “time” lost and the destruction of the “compounding effect.”
What They Don’t Tell You
The fellow cites the compounding effect. You are familiar with its enriching dynamics.
A 10% return on a $100 investment is lean. Yet a 10% return on a $1,000,000 investment is handsome.
Thus as a portfolio accrues across time, the greater the returns it amasses.
Yet here is what the buy and hold crowd omit from their analysis:
A disruption of the compounding phase can discombobulate the entire compounding mechanism.
That is because bear market losses are not “symmetrical.”
The Cruel Mathematics of Bear Markets
Assume a bear market claims 20% of your stock market wealth. You assume you will emerge with a whole skin once the stock market advances 20%.
Yet have another guess, argues Mr. Roberts. The mathematics voice a different tale:
- Losses hurt more than they appear because recovery isn’t symmetrical. If your portfolio drops 20 %, you need a 25 % gain to get back to even. Drop 30 %, and you need nearly 43 %. A 50 % loss? That takes a 100 % rebound. These aren’t abstract numbers; they’re the reality of compounding in reverse.
You recall the stock market losses of the Great Financial Crisis, 2007-09.
The S&P endured a 56% whaling across that nightmare space.
Yet investors did not require a 56% recovery to make their losses good. They required instead a 113% recovery.
Only in 2013 did their heads rise above the waterline — a six-year journey to the surface.
Bear Markets Are “Mathematical Traps”
Thus substantial market reversals constitute “mathematical traps,” explains this market Cassandra:
- When looking at things in percentages, gains and losses of equal size do not cancel out. A 10 % gain and a 10 % loss still leaves you down. If you start with $100,000, gain 10 % to $110,000, then lose 10 %, you’re at $99,000… High volatility drags on returns even if long-term averages look fine…
- Drawdowns are more than temporary events. They are mathematical traps. The deeper the fall, the more challenging the climb. And every investor who ignores this does so at their own risk…
- Don’t let the numbers fool you. A 20 % loss is not a bump in the road. It’s a reset. It costs you capital. It costs you time. And it drags your plan off course. The damage runs deeper than the headlines suggest.
Average Returns vs. Actual Returns
And so Mr. Roberts sketches a razor sharp distinction between average returns — and actual returns.
The two differ as night and day differ, as ice and fire differ, as circle and square differ:
- Let’s assume that an investor wants an “average” rate of return over a five-year horizon. Since markets have volatility, we can inject a minor correction to see the impact of losses.
- After three straight years of 10% returns, a bear market loss of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the required average rate of return.
- There is a significant difference between AVERAGE and ACTUAL returns. The impact of losses destroys the annualized “compounding” effect of money.
Beware the Bear
In conclusion:
- If your plan is based on compounding returns over 20 or 30 years, even a short disruption can have long-term effects. This effect is worse for those nearing retirement. If a bear market hits five years before retirement, you don’t have time to wait.
- You may need to delay retirement, reduce your spending goals, or work longer. Worse, the damage is permanent if you’re already retired and drawing down funds during a bear market as every withdrawal during a downturn locks in a loss.
- Even if the market recovers, your portfolio doesn’t, because you pulled money out when prices were low…
- Investors often plan as if markets will deliver average returns smoothly. They don’t. Bear markets distort the timeline, and time lost compounds into permanent gaps in your financial plan…
Time to Buy an Umbrella?
This Roberts fellow sketches the scene in very dark colors.
Of course, he does not know when heavy weather will next come barreling through Wall Street.
Nor do I — or the heaviness of that weather.
Yet I am most alarmed by extended fair weather. That is when guards come down.
And when guards come down, mine goes up. My guard is presently up.
Yet few purchase umbrellas when blue skies stretch to the horizon.
Come the inevitable downpour, most are caught in the open, unprepared.
Perhaps now is the time to purchase your umbrella.
Many are available — and at a buyer’s price.
Regards,
Brian Maher
for Freedom Financial News
