4 ways to prepare for the next bear market

They say hindsight is 20/20 and that’s never truer than when it comes to the stock market.

When looking back at past corrections and bear markets, it’s natural to see all the factors that led to the downturn. However, the picture is much foggier when you’re trying to figure out when the next one might happen.

In fact, the evidence is that no one can consistently forecast the future direction of the markets – either up or down. Of course, this doesn’t prevent analysts, media pundits and investors from trying to predict the next crash.

As we’ve observed in recent episodes of our Capital Topics podcast, the doomsayers have been particularly vocal of late. They’re saying we are headed for a stock market correction or even a bear market because of the relatively high valuation levels of the markets.

The equities markets have had a strong run. For example, the U.S. market’s total return over the 10 years to January 31 was 17.8%, more than double the long-term expected return. However, experience teaches us that relative valuation metrics tell us very little about the timing of market pullback.

What are corrections and bear markets? A market correction is a drop of 10% to 20% from a recent peak. They usually don’t last very long. After a few weeks or months, the market recovers the losses. Corrections are quite normal; they allow the market to consolidate and take a breather before going higher.

A bear market is more serious. It’s when markets drop more than 20% from their recent highs. They usually last much longer. The triggers for a bear market vary greatly, but they are generally related to poor economic data, a geopolitical crisis or the bursting of a market bubble.

Since 1926, the S&P 500 has experienced 17 bear markets with declines ranging from -21% to -80%, according to this report from Dimensional. The average length of these bear markets was 10 months. The longest bear market was in the early 1930s, lasting 27 months, and the shortest one was the COVID crash two years ago. It lasted just one month.

As humans, we’re not wired for negative market volatility. Behavioural science has demonstrated it triggers our fight or flight instinct, and that’s why investors often make wealth destroying errors during a downturn.

Bear markets are when Investors learn their true tolerance to risk. For the long-term investor, they’re actually a time of great opportunity. But for those who panic, they almost always lead to a permanent loss of capital. That’s why it is crucial to be mentally prepared. A big drop may not happen tomorrow, this month or this year, but you can be sure one will occur sooner or later.

So, how should you prepare yourself for the next drop?

• Have a plan—You won’t be surprised by this piece of advice. You need to have an investment plan that you’ve laid out when the markets were calm and your emotions were in check. The plan must take into consideration your need and willingness to take risk as well as your time horizon. Remember that taking too much risk may lead you to bail out of the markets at the wrong time.

• Have a safe bucket—The best way to reduce risk in your portfolio is to have an allocation to high-quality short duration bonds. This safe bucket should be built with government and other top-quality bonds. Bonds hold their value in a bear market and may even gain, offsetting some of the losses in your equity bucket. If you are a retiree pulling money from your portfolios for living expenses, our advice is to have enough money invested in bonds to cover five or more years of annual withdrawals. This will help you stay the course until equities recover.

• Rebalance regularly—Rebalancing ensures your portfolio reflects your risk profile and capacity for risk. This is especially important during a prolonged bull market when many investors grow comfortable holding a larger percentage of stocks in their portfolios

• Tune out the noise—Finally, keep your emotions in check by tuning out the media noise. Embrace the fact that corrections and bear markets are unavoidable and unpredictable. One day they will end. Remember that if you stay disciplined and stick to your long-term investment plan in a bear market, you will be rewarded when the next bull market comes around.  

Source: Dimensional