Although they are a natural part of the investing experience, there’s a certain taboo about discussing bear markets and recessions, as if acknowledging them increases the likelihood of experiencing one. (Getty)
A “bear market” occurs when there is a greater-than-20% peak-to-trough drop in the S&P 500. Although the 20% threshold is arbitrary, crossing this level has historically been an important dividing line between painful-but-short-lived corrections—where recovery time is measured in months—and the years-long recovery period for bear markets.
Although they are a natural part of the investing experience, there’s a certain taboo about discussing bear markets and recessions, as if acknowledging them increases the likelihood of experiencing one. Our research suggests that this taboo is counterproductive. In studying bear markets closely, you will learn that they aren’t as dangerous as they seem.
It’s important to note that there is no panacea for bear markets. Almost all investors will experience at least a handful of bear markets—both in their working years and during retirement—and they will be painful. But there’s a difference between pain and damage, and our research tells us that bear market protection doesn’t have to be expensive—especially if investors are proactive.
However, bear markets needn’t be a threat to financial success. In fact, for the well prepared, they can be an opportunity to improve long-term returns.
No matter how well intended or designed, the strategies that provide the most potent protection against equity downside risk also tend to be the most costly in terms of sacrificing long-term growth potential.
That’s particularly true if the goal is to hedge against all downside movements, instead of only against the long and deep sell-offs that characterize bear markets. That’s because—in order to make sure that there is a high negative correlation during all downside episodes—a strategy must risk also having a high negative correlation when markets go higher. In a world where stocks usually go higher, strategies that seek to go “short” or directly hedge equities seem doomed to fail. This cost is especially high for strategies that employ leverage to “make the most” of their short windows of opportunity.
As a result of these challenges, we don’t usually recommend direct hedges as a part of our strategic or tactical asset allocation. It’s important to prioritize cost-effective protection before moving onto less-reliable or costlier hedging strategies.
Here are some “damage mitigation” strategies, in declining order of efficiency:
1. Think structurally
Make sure that your portfolio is taking the right amount of risk to meet your short- and long-term objectives.
2. Plan strategically
The most direct way to manage equity risk is to trim some stocks from the portfolio in favor of a higher allocation to core bonds.
3. Consider hedges
There are many strategies that could mitigate the portfolio’s downside exposure if used to replace a part of the equity allocation.
4. Manage liabilities prudently
If used carefully, borrowing strategies can be highly beneficial to improving bear market returns.
Although bear markets are painful, it usually only takes a few years for the stock market—and even less time for balanced, diversified portfolios—to fully recoup bear market losses. Even in a worst-case “super bear market,” market losses are temporary for investors who are able to stay the course.
For a deeper read, download the full whitepaper, “ Bear market guidebook: How to manage risk and harness opportunity in a market downturn .”
After reviewing this research, you can work with your financial advisor to make sure you’re prepared. It’s never too early—and rarely too late—to plan.
