It is strange to contemplate, but we are now just a few months removed from the tenth anniversary of the previous market top of October 9th, 2007. Over the next year and a half, the ensuing bear market would go on to erase almost 60% of the S&P 500’s peak value, shaking the confidence of many investors in the efficacy of equity investing, something which previously had been considered unthinkable.
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Considering that my livelihood is derived from helping others invest, it should come as no surprise that those were very trying times, not least because the seemingly daily precipitous declines in the value of my clients' accounts made me question whether I was giving good advice, let alone adding any value.
In reality, however, I consider the experience of the 2007-2009 bear market to have been the most important of my career. By the time it had begun, I had already spent several years as an understudy in the industry, during which I had occasion to observe the very different bear market that began with the bursting of the tech bubble. A couples year later, after graduating with a finance degree, and passing my securities exams to become a registered rep in 2005, I felt certain that I could handle anything the markets and my new responsibilities could throw at me. After all, I had read all the market history I could find, and I had committed to memory all the relevant data points about equities rising inexorably, despite long bouts of volatility and stagnant returns. Yet what I had not fully realized, and what came as an epiphany, is that bear markets are unique in every case.
Here are a few of the most important lessons I learned during the last bear market:
- Though they can have similar characteristics in terms of market declines, no two bear markets are ever alike. Some are precipitous and short-lived, such as 1987, while others can be years in duration, fueled by prolonged deflation or inflation, such as the 1930s and 1970s. It is nice to know that the average bear market runs it course after a little more than a year, but that is little consolation when you are in the midst of one, and an end to the selling is nowhere in sight.
- Looking to previous bear markets for cues as to what assets might aid your portfolio in riding out the next one is of only minor utility. For example, in the 2000-2002 bear market, not all sectors got hammered, and a few actually did reasonably well. Likewise, investment grade corporate bonds gained during that cycle as rates fell, driving up bond prices. But in a liquidity-driven bear market such as 2007-2009, during which credit markets freeze and margin calls force selling, many asset correlations can rise toward 1. Diversification is great most of the time, but in some rare instances, few assets other than cash and government bonds retain anything like a semblance of their intrinsic value.
- Rebalancing, while a net drag on returns in a rising market, can be a lifesaver in a nasty bear market. The simplest way to think about rebalancing is that it is selling when you want to in order to prevent having to sell when you have to do so. This is an obvious oversimplification, but I find it helps people, - especially those in retirement who are drawing an income from their portfolio, - understand (to paraphrase Benjamin Graham) that prudent portfolio management is not so much about return maximization as it is about risk mitigation.
- Maintaining a large position in any sector of the market can be risky, but when it is a sector like financials that are heavily regulated and scrutinized, the risks of an overweight position are magnified, not least because in a crisis situation, the government is sure to intervene, and how it does so can be very messy. Of course, in 2007-2009, most financial companies that suffered losses had only themselves to blame for imprudent behavior in the boom times, but the fact remains that a lot of the pain in the industry was probably unnecessary, especially since the terms of the government bailout seemed to be changing constantly, and some companies were bailed out (Bear Stearns), while others were left to fail (Lehman Bros). Financial stocks, historically, have delivered magnified results both on the upside and on the downside, and investors should be particularly wary of concentrated positions in this sector.
- While many people think the role of an adviser is to "beat the market," the true role of a financial adviser is to temper enthusiasm during bull markets, and to stop clients from doing something stupid during bear markets. In real time, the value-add of an adviser is difficult to quantify, but after a few years, once the dust has settled, the value becomes more apparent.
- You can try to save them all, but you will not succeed. Some people think they are cut out for investing, but when things go south, there is usually nothing that will stop them from selling out. It is unfortunate, but it is a necessary lesson to learn. It is not just that some people will not make good investment clients, it is that they cannot be good investment clients. You are better off trying to steer them in a direction where they are more likely to succeed, whether that is CDs or whatever. Just as a prudent investor cuts his losses on irredeemable positions, prudent advisers must learn to cut their losses on relationships that turn out not to be mutually beneficial, let alone mutually profitable.
Most importantly, bear markets are where you make most of your money, as Shelby Davis famously said. The dangerous part of a bear market is not the sudden drop in the value of your investments, but in how you react to that drop in value. For the enterprising investor, bear markets can provide all sorts of opportunities to take advantage of dislocations in asset prices. It is always difficult to buy into a bear market with your own money, let alone convince someone else to do it, but for long-term investors, market declines should be welcomed, not feared.
This article first appeared on http://www.fortunefinancialadvisors.com/