Bearing Gifts

John Lim

AFTER A DECADE of rising stock prices, it’s time to look forward to the next bear market—and the three big benefits it’ll confer.

First, a market decline is a great financial gift, but only if you continue to save and invest. While it certainly won’t feel like a gift, a bear market enables you to invest at lower prices, both by adding new savings and reinvesting dividends.

Imagine you could choose from among three possible stock market scenarios. In scenario No. 1, the stock market climbs steadily in a straight line for 30 years. In scenario No. 2, you’re hit with periodic bear markets over the three decades. In scenario No. 3, stocks go nowhere for years, before powerfully rallying toward the end of the 30-year period. In all three scenarios, the market averages end up at the same level. The only difference is the path taken to get there.

Assuming you’re in the workforce the entire time, and saving and investing consistently, which stock market would you choose to live through? If you picked scenario No. 3, congratulations. That’s the best market scenario if you want the greatest wealth at the end of the 30 years, because it offers the chance to buy stocks at lower prices, on average. What if you chose No. 1? Sorry, that’s the worst one. Meanwhile, No. 2 is somewhere in between.

If you behave properly, by not selling and instead continuing to buy stocks, the more bear markets you have during your savings years, the greater the likelihood that you will ultimately retire with a larger nest egg. This may seem counter-intuitive. But remember, over very long time periods—think multiple decades—stock markets should mean revert. In other words, years of underperformance tend to be followed by years of outperformance—and those years of underperformance offer a great chance to buy shares cheaply.

Second, we only learn our true risk tolerance by living through bear markets. Fred Schwed wrote the celebrated 1940 book about Wall Street, Where Are the Customers’ Yachts? In it, he offers this memorable passage: “Like all of life’s rich emotional experiences, the full flavor of losing important money cannot be conveyed by literature. You cannot convey to an inexperienced girl what it is truly like to be a wife and mother. There are certain things that cannot be adequately explained to a virgin by words or pictures.”

There’s no way to know ahead of time how you will feel and, more important, how you will behave after losing a significant amount of money in the stock market. Asset allocation is the key determinant of your investment returns. Taking on more risk, by allocating more to stocks, should translate into higher returns over the long run.

But how much risk can you tolerate without losing sleep and bailing on stocks during a bear market? One of the most important things in investing is to understand yourself, because we are our own worst enemy. Living through a bear market is really the only way to discover the mix of stocks and bonds we’re comfortable living with.

In fact, I advocate that young adults start out with an 80% stock-20% bond mix, even though many “experts” would scoff at this and advocate a 100% stock allocation. A 100% stock allocation only maximizes your long-term returns if you don’t panic and go to cash the first time you experience a bear market.

Maybe you’ll experience a bear market with an 80-20 portfolio and barely break a sweat, continuing to rebalance as you’re supposed to. In that case, going forward, you might raise your stock allocation to 90% or more.

Third, bear markets put the kibosh on bull market foolishness. Not only do higher stock prices make investing riskier, but also the resulting euphoria sucks more people and more money into the market at the worst possible time.

Perhaps the one certainty in investing is the cyclical nature of markets and human psychology. This long into a bull market, it’s easy to forget that stock markets can suffer terrible and terrifying short-term losses. One of my favorite quotes is from Sir John Templeton: “Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.”

Optimism is contagious. You may believe that you think and act independently. But when things are going well in the economy and optimism is rampant, it’s hard to resist the herd mentality. That’s simply how we are wired. Recall the late 1990s dot-com bubble. Near the peak, how many people did you know who weren’t invested in tech stocks? Want a more current example of the increasing flow of money fueled by optimism? Look no further than this year’s IPO market.

A bear market will certainly dent your portfolio in the short run. But it might just save you even more in the long run—if it prevents you from falling prey to future market euphoria and the risky behavior that so often ensues.

Even if we don’t get caught up in the optimism around us, we aren’t immune to its effects. When market participants engage in increasingly risky behavior, it raises the riskiness of markets for everyone. Never forget the cautionary words of Warren Buffett: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”

John Lim is a physician who is working on a finance book geared toward children. His previous article was Lay Down the Law. Follow John on Twitter @JohnTLim.

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