With the stock market close to entering an official bear market (defined as a decline of 20% from its recent high), there are some hard truths that we as investors need to accept to be successful over the long term.
In 1979, Daniel Kahneman and Amos Tversky conducted a study on a topic called loss aversion (these two researchers are well-known in the field of behavioral finance). The basic idea was to test how people reacted to losses vs. how they reacted to gains. In a nutshell, the study revealed that the psychological pain of losing was about twice as great as the joy experienced from gains. Another way of saying this is that the pain of losing $100,000 is about twice as powerful as the joy of gaining $100,000.
If you think about your own experiences with gains and losses in the markets, I expect you roughly agree with this. It’s also why when the stock market (as measured by the S&P 500 index) starts to decline, investors start to react. Many sell to stem or stop the pain.
If the loss was permanent, one could argue it may be prudent to react quickly to a loss. But in the financial markets, that has not been the case. Historically, stock market declines have been temporary, and rationally it’s fair to assume that future losses will be temporary as well.
When making investment decisions during a bear market, it’s helpful to understand that the psychological pain you may feel is real. It’s rooted in human nature. Most people feel it. But overreacting to the pain is generally not the best strategy if your goal is long-term wealth accumulation, or if you need to live off the returns from your portfolio for decades in retirement. The highest probability strategy is to stay invested. History has borne this out.
That being said, it doesn’t mean you should avoid any adjustments. For instance, you may need funds for living expenses, and not knowing when the recovery may arrive, it can be prudent to raise funds. Or you may fundamentally discover you just don’t want that much volatility, so you cut back some, but stay fundamentally invested. Or, market dynamics and valuations change, so you make some adjustments. But a wholesale departure from markets is usually not the best approach. You end up selling when markets are down and likely buying later after they are much more expensive.
Bear Market Realities
Bear markets are an inherent part of investing. On average, they happen about every seven years, and the average decline is about 34%. Since 1940, we have had 12 bear markets, and three since the year 2000 (this current negative cycle may become the fourth).
Sometimes bear markets are short-lived (like in 2020), and sometimes they stretch for several years (as in 2008). Yet despite all this, the stock market has continued to increase in value over the years, plus delivering dividends to investors every year. The returns from stocks have been critical to investors building financial independence, particularly since 2008, when interest rates on investment-grade bonds have consistently been below the inflation rate. And regardless of how the inflation issue is ultimately handled by the Fed, going forward, we are likely to face an investment environment where interest rates on bonds do not exceed inflation. That means it will be difficult to build or live off your wealth if you avoid stocks.
Each Bear is Different
Every bear market, however, is different, and many investors have that nagging suspicion that maybe this time it won’t recover. We understand that concern, but investment theory doesn’t have a good answer to this. The assumption is economies and corporate profits grow, leading to stock price appreciation and increasing dividends. It’s the timing of the price appreciation that is the issue. It’s unpredictable and volatile, but the long-term trend has been meaningfully positive.
If someone truly does not believe the stock market will recover (or doesn’t want to bear the risk that it won’t), then they likely should not invest. But not investing has risks as well. It’s difficult to build wealth and live off it if you don’t invest in equities.
We know bear markets are painful and we feel it as well. We’d prefer if we didn’t have them, but there is a basic boom and bust cycle to markets that investors just can’t escape. In the good years, prices often do not reflect the odds of bad things happening, and in the bad years, prices often do not reflect the odds of good things happening. We don’t know why that is It’s just the way markets work. And if investors want to participate in them and benefit from their wealth-building capacity, it’s something they must accept.
While we hope this negative market cycle is over soon, realistically, we see fair odds it could drag on for a while. It will take time to determine if the Fed can bring down inflation to its 2% target, or somewhere close to that. We don’t know exactly what the Fed will need to do to achieve this. It doesn’t know either. The Fed has to react as the economy changes. But we do believe that at some point the inflation issue gets solved, and markets will move on to a recovery stage.
Staying fundamentally invested has been the highest probability strategy for markets. We encourage you to contact us if you have questions about your portfolio allocation or markets. We are more than happy to talk through these issues with you as it relates to your personal situation.
Important Disclosure: The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and may be modified due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed. Beacon Pointe has exercised all reasonable professional care in preparing this information. The information has been obtained from sources we believe to be reliable; however, Beacon Pointe has not independently verified or attested to the accuracy or authenticity of the information. The discussions, outlook, and viewpoints featured are not intended to be investment advice and do not consider specific investment objectives or risk tolerance you may have. All investments involve risks, including the loss of principal. Consult your financial professional for guidance specific to your circumstances.