How to hang on during a wild stock market ride

This post was originally published on this site

For most of the past decade, stock investors benefited from a long bull market that suggested making money was easy and natural.

Then all hell broke loose about the end of February. The market seemed to be in free fall one day, on a skyrocketing upward course the next, then in free fall once again, with no end in sight.

As you know, the turmoil was caused by a noneconomic force that seemed to come out of the blue — a scary virus spreading quickly around the world. Investors had no way to know this was coming. Yet seasoned investors had ample reason to expect that something would rattle our nerves and replace a decade of stock-market nirvana.

“When we get scared, we forget that it’s normal to be ready for bad things to happen,” wrote author Annalee Newitz in an opinion piece in the New York Times in February. “It’s not overreacting; it’s just how we get through life.”

Right now, investors face two challenges. First, navigating the current crisis. Second, preparing for the next one — because sometime in the future there will be a next one.

Read: Why an oil price war is wreaking havoc on financial markets right now

The first challenge is tough: You can’t immediately solve it, at least not in a way that makes sense. When you’re on a roller coaster that suddenly is asking your body (and your mind) to tolerate too much, you can’t just jump off.

When your investments seem to be suddenly threatening your financial future, it’s often possible to jump ship by bailing out of your investments. But not a good idea.

The evidence is overwhelming that bailing out in times of stress is what keeps people from being successful long-term investors.

Whether you’re riding an amusement park roller coaster or a wild stock market that seems out of control, the best course is exactly the same: Hang on, think about something else, and know that you’ll get through it.

The second challenge is to prepare your portfolio and your expectations for another potentially severe setback. To accomplish this, you’ll need to confront the emotional teeter-totter of greed vs. fear — neither of which is worth indulging, by the way.

Read: Here’s the EPA’s list of over 300 coronavirus-fighting cleaning products

For many U.S. stock investors, greed has had the upper hand since sometime about 2010. As the market SPX, -6.21% gained year after year after year, fear (of a correction or a severe bear market) got pushed into the back seat, maybe even to the back recesses of the trunk.

The past decade of easy financial success might have done a disservice to a generation of new investors. These young investors probably know about the losses their parents’ generation suffered in the 2008-09 housing and financial crisis. But those losses are easy to forget when everything seems to be going so well.

The best way to meet the second challenge I identified — preparing your emotions and your portfolio for bad times — is to learn from the past.

Stock-market losses are normal and should be expected. I often tell people I can guarantee that if they invest in equities, they will lose money. Just as important, you should know that, at least over the past 90 or so years, the market has always recovered.

For some perspective, you can look at a set of interesting charts that show the ups and downs of the U.S. stock market during various periods from 1929 through March 6 of this year.

The very first graph you see shows the past 12 years: a very steep 15-month decline followed by a full recovery and then seven-plus years of a bull market.

The second graph shows two severe bear markets from the first decade in this century.

The emotional lesson I think you should learn: Bad things happen; that’s just the way it is.

That’s the bad news. The good news is that you can fine-tune your portfolio so it’s ready for the worst times and surprises.

Investing in equities is all about accepting and managing risk. That might seem like a daunting task, but it’s actually quite possible if you’re willing to examine some investment returns from the past, then examine your own psyche, and see how they fit together.

To restate what is well known: In broad terms, if you want high returns, you have to take significant risks. If on the other hand you want to seriously minimize risk, you’ll need to settle for lower long-term returns.

By far the most effective way to reduce risk is to adjust the balance of your portfolio between stocks and bonds.

To illustrate how this works, I’ll present some comparisons from the past 50 years. Stocks are represented by the S&P 500 index. Bonds are represented by a combination of intermediate and short-term government bonds plus TIPS.

In the table below, You’ll see the results for three quite different allocations: 20% equities for the very conservative investor, 50% equities for the moderate investor, and 100% equities for the aggressive investor. In each case, the remainder of the portfolio is in intermediate-term Treasury bonds.

Three choices of bonds vs. equities, 1970-2019

Percent in S&P 500 Compound return Standard deviation Worst 12 months Worst drawdown
20% 7.8% 4.3% -8.6% -8.9%
50% 9.0% 8.1% -23.2% -25.9%
100% 10.6% 15.0% -43.4% -50.9%

I have long believed that a moderate allocation of 50% in equities may be suitable for many — perhaps even most — investors, including those who are retired. This is the approach I take with my own investments.

But younger people who are accumulating assets can afford to take more risk, and they should do so. Likewise, investors who are quite uncomfortable with equities may want to limit their stock exposure to 20% or 30%.

Read: Coronavirus: Separating the facts from the hype — and what’s the risk for older people?

Fortunately, there are lots of choices. You’ll find other combinations, in 10% increments of equity exposure, in this table.

There are a lot of numbers in this table, but if you take the time to study the worst periods, ranging from three months to 60 months, you’ll get a sense of what you’re likely to have to withstand in order to earn the expected long-term rates of return.

You’ll see that “staying the course” meant sucking it up enough to accept bear-market losses exceeding 50% in 1973-74, 2000-2002, and again in 2008. And this doesn’t even mention a sickening one-day loss of 22.5% in October 1987.

I can’t promise an end to wild stock-market rides. But I’m pretty sure that if you use this tool to find the right balance for your portfolio, you’ll find it much easier to hang on during that ride.

I’ve also tracked variations on these 50 years of results. One variation includes international stocks; another limits the equities to value stocks.

For more information on all this, check out my podcast, “Fine Tuning Your Asset Allocation.”

Richard Buck contributed to this article.