Bear Markets are a Necessary Evil

With the sharp drop in US equities investors have experienced, and the questions I have been getting about the drop, I thought I would update a piece I wrote back in 2008 explaining why bear markets are a necessary evil.

A “necessary evil” can be defined as an unpleasant necessity, something that is unpleasant or undesirable but is needed to achieve a result. An example of a necessary evil is taxes. Investors should also view bear markets as a necessary evil. Let’s explore why.

Perhaps the most basic principle of modern financial theory is that risk and expected return are related. We know that stocks are riskier than one-month Treasury bills (which is considered the benchmark riskless instrument). Since they are riskier, the only logical explanation for investing in stocks is that they must provide a higher expected return. However, if stocks always provided higher returns than one-month Treasury bills (the expected always occurred), investing in stocks would not entail any risk—and there would be no risk premium. In fact, in 26 of the 99 years from 1926 through 2024—more than one-quarter of the time—the S&P 500 Index produced negative returns. In addition, there have been four periods when the S&P 500 Index produced much greater losses than the 34% loss experienced during the COVID-19 crisis that began on February 19, 2020 and lasted through March 23, 2020:

· January 1929-December 1932, loss of 64%.

· January 1973-September 1974, loss of 43%.

· April 2000-September 2002, loss of 44%.

· November 2007-February 2009, loss of 51%.

The very fact that investors have experienced such large losses leads them to price stocks with a large risk premium. From 1926 through 2024, US equities (CRSP 1-10 index) returned 10.2%, providing a 6.9% annualized risk premium over one-month Treasury bills return of 3.3%. If the losses that investors experienced had been smaller, the risk premium would also have been smaller. And the smaller the losses experienced, the smaller the premium would have been. In other words, the less risk investors perceive, the higher the price they are willing to pay for stocks. And the higher the price-to-earnings ratio of the market, the lower the future returns.

The bottom line is that bear markets are necessary to the creation of the large equity risk premium we have experienced. In other words, the equity risk premium is not a free lunch, and bear markets are a feature of the market, not a bug! Thus, if investors want stocks to provide high expected returns, bear markets (while painful to endure) should be considered a necessary evil. Investors must also acknowledge that it is a virtual certainty that the risks will show up from time to time. As much as we would like to think there is someone out there who can protect us from bear markets, there is only one being who knows when, how long and how severe the periods of underperformance will be—and none of us gets to speak to him (or her).

It is during the periods of underperformance that investor discipline is tested. Unfortunately, the evidence suggests that most investors significantly underperform both the stock market and the very mutual funds in which they invest. The reason for the underperformance is that investors act like generals fighting the last war. Subject to recency bias (the tendency to overweight recent events/trends and ignore long-term evidence), they observe yesterday’s winners and jump on the bandwagon—buying high—and they observe yesterday’s losers and abandon ship—selling low. It is almost as if investors believe they can buy yesterday’s returns, when they can only buy tomorrow’s.

There are several explanations for this outcome. The first is that investors allow their emotions to impact their investment decisions. In bull markets, greed and envy take over, and risk is overlooked. In bear markets, fear and panic take over, and even well-thought-out plans can end up in the trash heap of emotions.

The second explanation is that investors are overconfident of their ability to deal with risk when it inevitably shows up. They believe they can stomach losses of 20, 30, 40 or even 50 percent and stay the course, adhering to their plan. However, the evidence demonstrates that investors are as overconfident of their investment abilities as they are of their driving skills (studies have found that the vast majority of people believe they are better than average drivers).

The third explanation is that investors often treat the likely (stocks will outperform Treasury bills) as certain and the unlikely (a severe bear market) as impossible. The result is that they take more risk than is appropriate. When the risks inevitably show up. they are “forced” to sell.

The Keys to Successful Investing

There is an old adage that “those who fail to plan, plan to fail.” Therefore, the first key to successful investing is to have a well-thought-out plan that includes an understanding of the nature of the risks of investing. That means accepting that bear markets are inevitable, and they must be built into the plan. It also means having the discipline to stay the course when it is most difficult to do so (partly because the media will be filled with stories of economic doom and gloom). What is particularly difficult is that staying the course does not just mean buy and hold. Adhering to a plan requires that investors rebalance the portfolio, maintaining their desired asset allocation. That means that investors must buy stocks during bear markets and sell them in bull markets—which brings us to the second key to success.

While academic research has found that almost all the risk and return of a portfolio is determined by the portfolio’s asset allocation, the actual returns earned by investors are determined more by the ability to adhere to whatever the allocation they chose than by the allocation itself. Thus, the second key to successful investing it to be sure you do not take more risk than you have ability (determined by your investment horizon and stability of income), willingness (risk tolerance) and need (the rate of return needed to achieve your objectives) to take. Those who avoid excessive risk-taking are the ones most likely to stay the course and avoid the buy high/sell low pattern that bedevils most investors.

The third key to success is to understand that trying to time the market is a loser’s game—one that is possible to win but not prudent to try because the odds of doing so are so poor. Listen carefully to legendary investor Warren Buffett’s statements regarding efforts to time the market:

· “Inactivity strikes us as intelligent behavior.”

· “The only value of stock forecasters is to make fortune-tellers look good.”

· “We continue to make more money when snoring than when active.”

· “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”

Buffett also observed: “Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’ If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.”

Perhaps Buffett’s views on market-timing efforts are best summed up by the following from the 2004 Annual Shareholder Letter of Berkshire Hathaway:

Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

As Buffett stated, investing is simple but not easy. The simple part is that the winning strategy is to imitate the lowly postage stamp that adheres to its letter until it reaches its destination. Investors should stick to their asset allocation until they reach their financial goals. The reason it is not easy is that it is difficult for most individuals to control their emotions—greed and envy in bull markets, and fear and panic in bear markets. In fact, bear markets are the mechanisms that serve to transfer assets from those with weak stomachs and without investment plans to those with well-thought-out plans—with the anticipation of bear markets built into them—and the discipline to adhere to those plans.

The Moral of the Tale

Bear markets are a necessary evil in that their existence is the very reason the stock market has provided the large risk premium and the high returns investors can earn. But there is another important point investors need to understand about bear markets. Investors in the accumulation phase of their careers should view bear markets not just as a necessary evil but also as a good thing. The reason is that bear markets provide those investors (at least those who have the discipline to adhere to their plan) with the opportunity to buy stocks at lower prices, increasing expected returns. It is only those in the withdrawal phase (such as retirees) who should fear bear markets because withdrawals make it more difficult to maintain the portfolio’s value over the long term. Thus, those investors have less ability to take risk, which should be built into their plan.

The bottom line for investors is this: If you don’t have a plan, immediately develop one. Make sure it anticipates bear markets and outlines what actions you will take when they occur (doing so when you are not under the stress that bear markets create). Put the plan in writing in the form of an investment policy statement and an asset allocation table and sign it. That will increase the odds of your adhering to it when you are tested by the emotions caused by both bull and bear markets. And then stay the course, altering your plan only if your assumptions about your ability, willingness or need to take risk have changed.