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Rising fears of an impending economic downturn have added to investors’ fears that things could continue to get worse. Beyond the traditional measure of stocks being at least 20% below the prior peak, last week’s piece discussed that the recent widespread selling appears to qualify it as a “real” bear market. This piece will provide three crucial rules for surviving and thriving after the bear market.
Rule number one: keep it all in perspective. While the natural instinct is to focus on the market being down by more than twenty percent from the recent peak, looking at a more extended timeframe can help frame the situation better. Over the last five years, $100 in the S&P 500 grew to $187, an annualized return of over 13%! This return far outpaced bonds and cash. And on the more critical point of increasing purchasing power, stocks rose significantly faster than inflation. Investors bled purchasing power if invested in bonds and cash.
Long-term, stocks have outperformed real estate, bonds, and cash despite wars, a depression, financial crises, and numerous recessions. According to data from Jeremy Siegel, stocks have outperformed bonds and stocks more than 80% of the time in 10-year periods since 1871. While stocks clearly underperform in some periods, they outperformed in 100% in 30-year periods. Historically, stocks are unrivaled in growing after-inflation wealth over the long term.
Buying stocks after a 20% decline has typically led to better returns over the following one and three-year periods. There are no guarantees that stocks will recover quickly, but the median bear market lasts about a year. Since there have been some extreme outcomes in the past, the duration of bear markets varies widely. For example, the stocks fell by -86% from 1929 to 1932, which coincided with the Great Depression. In any case, stocks have always recovered eventually, as evidenced by their impressive long-term performance.
Rule number two: avoid ruin. On a personal basis, this means that one should have enough liquid assets to cover living expenses over a reasonable period. Since bear markets have rarely lasted more than three years, that seems like a suitable place to start, but personal circumstances differ. The key is to position yourself so you are not forced to sell stocks at an inopportune time.
On the stock investment side, focus on “knowing what you own” and on companies that can survive a possible oncoming recession and thrive after it is over. While Warren Buffett began his investing career buying “cigar butts,” low-quality but cheap companies with one more “puff” left in them, he evolved to focus on higher-quality companies with Charlie Munger’s influence. Buffett now says that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Benjamin Graham, Buffett’s mentor, taught him much about value investing, but one of the essential truths was to analyze stocks as a business and not react to short-term fluctuation in the quoted price of a stock. According to Buffett, chapters eight and twenty of Benjamin Graham’s “The Intelligent Investor” book teach the fundamentals of investment success.
It also helps to follow Graham’s advice to look at stock holdings as owning a part of various businesses, like being a “silent partner” in a private company. Hence, stocks should be valued as a portion of the company’s intrinsic value, not as something that has a constantly changing price on the stock market. An investor should take advantage of the stock market’s fickle view of a company rather than allowing it to dictate what one should do. Valuing stocks as a business and purchasing stock with a “margin of safety” enable investors to ignore the market’s vicissitudes. For Graham, the “margin of safety” meant buying at a price below the “indicated or appraised value,” which should allow an investment to provide a reasonable return even if there are errors in the analysis.
As a successful example of separating stock price from the company, Amazon
Rule number three: know yourself. Believe it or not, the human brain was not designed for financial markets. Our brains developed a long time ago with the express purpose of trying to keep us alive. For example, our first instinct is to flee when we feel fear. We are probably all here because our long-lost ancestors followed that feeling, so it isn’t all bad! That’s just one of many built-in biases that served us well in a different world but harm our decision-making in investing.
How can we overcome our feelings to make wiser investment decisions? One way to fight back is to know the actual probabilities around investment risks. The primitive side of our mind tends to overestimate the odds of large disasters and make them seem more common than they are. The statistics discussed in rule 1 were there for just that reason. Knowing the history and having a safety net of liquid assets to cover living expenses should ease the intense desire to sell stocks when they fall.
Another trick is to have mechanical investment rules that have a logical foundation. These rules allow investors to act without reacting to what our feelings are telling us to do. One example of a simple but effective mechanical control is periodic rebalancing. If your long-term target is 50% stocks and 50% bonds, rebalance back to that asset allocation on an annual basis or when either rises to ten percentage points above its target. This rule forces an investor to buy some stocks when they are underperforming and sell some when they are soaring.
Challenging markets are never pleasant, but they are at the heart of why stocks have been the best-performing asset class over time. An investor can profit from the dynamism of the U.S. and global economy by owning stocks. Still, it comes at the price of dealing with the volatility of the market caused by the reactions and overreactions of market participants.