Dear Mr. Market:
We typically write you letters about your volatile actions and the erratic behavior you bestow upon us as investors. Many of our letters also try to put certain economic events into perspective so that people don’t let your wild stock market swings force them into making bad decisions. All that said, it’s come to our attention that we can finally roll out the answer to a question that is not always obvious:
What should an investor do if a standard stock market correction turns into a bear market?
First off, let’s revisit the basic definition of a correction versus an official bear market. Click here for an article we wrote during the last correction in February, which incidentally at the time felt like the end of the bull market had finally come. Although the market sold off almost -10% in a short span, it clearly came back to reach record highs until October came around.
So…can we now apply the four most dangerous words in investing?
“It’s different this time”
Secondly, before we wave the “bear market” flag let’s inform you that very few stock market corrections ever turn into actual bear markets. The chart below shows you that only four have ever done so since 1974 so be prepared but odds are this is another correction.
What if it isn’t? We’re often asked what we do differently from other financial advisors and how we would react during a bear market.
If you haven’t read any of our previous material on how we design and allocate portfolios you’ll first need to know that we have long prepared for this potential storm. The old adage of “the best time to fix a leaky roof is on a sunny day” truly applies here. Almost all of our model allocations will have a portion of their respective mixes in the “Alternative Investments” bucket. A simple way of describing this are of investing is anything that doesn’t behave exactly like stocks or bonds.
Many years ago we started with a small (5%) allocation to Real Estate via REITs. We then gradually added in (3% to sometimes 7%) exposure to things like Managed Futures and Currencies. We even sprinkled in other investments like Long Short funds.
Most financial advisors and wealth managers will have you in a boilerplate portfolio that is nothing more sophisticated than a “60/40” mix (60% stocks and 40% bonds). Some may throw in a few other investments of the “alternative” variety but typically no more than 5% to 7% total. Very few investment advisors know (or admit) that to really move the needle on alternative investments in the hopes of helping your portfolio when you need them is that you should have at least 20% (sometimes up to 30% in that area!). Although it has been a drag for us on the way up, every single portfolio of ours has this allocation built into it!
What to do now if this indeed becomes a bear market lasting upwards of one year or possibly more? While most investors will simply have to ride it out we will actually gradually buy into stocks. No…we won’t simply be “chasing a falling knife” and mindlessly buy stocks as they fall deeper into a hole but rather strategically buy them back at cheaper valuations. Another way of positioning this is by ‘buying low’ (stocks) and ‘selling high’ (alternatives).
A very simple but potentially realistic approach to this is doing so in four distinct phases. Assuming you had your portfolio built up to at least our minimum of 20% allocated towards alternatives, you would now peel off about 5% from that part of the pie and buy stocks that have been beaten up. Moving forward into Q1 2019 and if we’re now indeed past correction territory (worse than -10%) we sell off another tranche of alternatives and put 5% more into equities. Let’s say there are a few more bear market rallies but all the while the stock market continues to basically struggle and we’re deep in a bear market; you then shave off another 5% and continue to reallocate towards stocks per your model allocation. At this point we’re at least six and maybe nine months into what now is a bear market and most investors are licking their wounds or sucking their thumb in a fetal position. Not you…nope….you still have at least 5% of “dry powder” left and you can sell the final piece of alternative investments you have and buy stocks as cheap as they’ll likely be!
Long story short, and as dumbed down as we could make this strategy appear…you did something very few investors will ever be able to do. You not only survived the bear market but on the upside and recovery that follows, you will almost assuredly have a larger portfolio than when it began to crumble. You’ll also be emotionally healthier and more stable than your neighbor who either buried their money in the back yard or is back at ground zero with nothing to show for it. It’s easier said than done but we’re telling you exactly how simple and void of emotion it can be.