How to think about stocks and bonds in a bear market

The key to investing health is lowering your expectations. A lot.

  • By William J. Bernstein,
  • The Wall Street Journal
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I’m old enough, hardened enough and grouchy enough to get increasingly annoyed at the sturm und drang that accompanies normal stock-market turbulence.

Even a 10% fall in the major indexes reliably increases the public blood pressure and induces media hyperventilation. At 20%, the outlets scream “bear market” despite the fact that a fall of 20% (or 18%, or 22%) tells one nothing about where prices are headed. Considering that once in a generation, share prices will halve—and in the decade between mid-1999 and mid-2009, it happened twice—that is a lot of wasted emotion.

Losses come with the territory, and even the Almighty himself wouldn’t be able to time the market deftly enough to enjoy the gains without the pain. Being surprised at equities’ ups and downs is like visiting Chicago in January and being shocked by 8 inches of snowfall. Come to the Windy City in winter and you had better bring your Mackintosh, galoshes and long underwear. Similarly, when you invest in stocks, be prepared to occasionally lose a large pile of money. In the U.S., those losses have always been temporary. So far.

The preparation for financial snowstorms is psychological rather than sartorial; to quote the great economist Yogi Berra: “Ninety percent of the game is half mental.” Investing, after all, is an operation that transfers wealth to those who have a process and can execute it from those who do not and cannot; from what I’ve seen, the average investor’s strategy consists of pride when prices rise and panic when they fall. Staying the course when the sky turns dark requires a more systematic approach, and being able to execute it depends almost entirely on one’s frame of mind.

Present/future wealth

How do you get to that healthy place in your mind? Your psychological investment overcoat is the fundamental equation of happiness:

Well-being = Reality minus Expectation

The lower your expectations, the better you will feel when things head south, and the better you feel the more likely it is that you will see your strategy through.

I’m no investing Spock; I felt pretty good about my portfolio in 1999 and 2006, and my stomach got plenty knotty in 2008-09. At the top, my mental accounting equalized my stock and bond holdings; consequently, I considered my net worth to be simply the sum of the two, a number that in retrospect was, at least temporarily, an agreeable fantasy.

In retrospect, my bull-market mental accounting was dumb; as the accompanying graph shows, the market reaches new highs on less than 5% of trading days, so 95% of days one dwells in the realm of losses, which isn’t a mentally healthy place to be. As stock markets around the world stumbled and fell, my brain gradually moved toward discounting the value of my stocks almost to nothing, and I held on to my bonds as tightly as a toddler clutches a teddy bear during a thunderstorm.

The long view

Which, if you think about it on a risk-adjusted basis, is as it should be all the time, not just when the market is in the tank. Stocks, prone as they are to heart-stopping falls, should never be counted as present wealth. If market history is a guide, a portfolio of global stocks likely will be worth more than today’s value in a decade, and yet more likely, but still not certainly, more in two or three decades. That is as much as you can say.

On a day-to-day basis, then, just write your stocks off and banish them from your consciousness; they’re future wealth, maybe, but don’t count on them for next week’s or next year’s groceries.

What about your bonds? The prudent investor mentally writes off a fair chunk of them, too. You want to buy stocks at the fire sale, don’t you? It would also be nice to not worry too much when you lose your job, incur medical expenses or send your adorable little gene-forwarding vehicles to a tony liberal-arts college. Any or all of these eventualities could at some point in your life consume a fair chunk of your fixed-income assets.

As such, I suggest you mentally vaporize all of your stocks and maybe half your bonds.

Retirement needs

Now for the good news: if you’re relatively young, can live off your salary and sock away some savings, your only potential immediate capital need is for big-time emergencies. Today, right now, you don’t need much in the way of savings.

But you will need some nice warm bonds when you retire. Along the way, if you’ve been prudent, disciplined and lucky, you’ve exchanged some of your stocks for bonds while the sun was shining and, better yet, used your savings or worked long enough to delay taking Social Security until age 70 (or whatever the future maximum benefit age is during your geezerhood).

You still don’t have to cash in all your stock chips, but it would be wise to have at least 10 years’ worth of safe bonds to meet your living expenses in case the market gods get angry early in your retirement. And if you still want to buy stocks at the fire sale, and especially if you want to endow the conveyors of your DNA into posterity, 20 or more years of bonds is even better.

Many will object to this grim calculus: “I don’t need to sell my stocks! Retiring with a 60/40 portfolio survives even the worst bear market.” That’s true only inside a spreadsheet. When the excrement hits the ventilating system during your 70s or 80s, it’s unbelievably hard to watch your bondholdings slowly evaporate and sell devalued stocks to replenish those bonds or pay your living expenses; it’s emotionally tolerable only if your burn rate is somewhere south of 3% annually. (And if you’re really lucky and your burn rate is less than 2% a year, then theoretically you don’t need bonds at all, since you can live off the dividends, which should grow at least as fast as inflation.

So, my advice is to mentally vaporize 75% of your portfolio, and when the crunch inevitably transpires, you will be psychologically well-prepared. In investing, to paraphrase the redoubtable Yankee catcher, psychology is destiny.

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