Why Investors Need to Embrace Bear Markets

Why Investors Need to Embrace Bear Markets

Though various financial experts have announced reassurance that the current market downturn isn’t going to be another 2008 collapse, we could be entering an extended bear market. Though it may seem counterintuitive, investors need to embrace bear markets. To elucidate this point, here is a metaphor taken from a recent Wall Street Journal blog:

Imagine you have a friend whose dream is to travel the world, but he has a deathly fear of airplane turbulence. He decides to wait to book his trip until the invention of planes that don’t experience any turbulence. Is he ever going to take that trip? Probably not. Investors who shy away from bear markets at all costs fall into the same flawed thinking. Instead, the best method of dealing with market volatility can be to ‘befriend the bear.’

Risk and Expected Return

An essential concept of economics is the link between risk and expected return. The one-month Treasury bill (T-bill) is the typical standard for ‘riskless’ investments. Stocks may be comparatively riskier investments, and the only motivation to take on that risk is the reasonable expectation of higher returns over the long run.

Remember, if the expected return always came to fruition, there would be no risk. If all stocks always produced higher returns than T-bills over the long run, there would be no reason ever to invest in a T-bill.

S&P 500: a Closer Look

When examining the S&P 500 year-by-year returns during the 90-year period from 1926 to 2015, we find 24 incidents of negative annual returns. That equates to a ratio slightly over one in four (27%). When focusing on multi-year periods in the same timeframe, three stand out as particularly unfavorable:

• January 1929 to December 1932 – S&P 500 down 64%
• January 1973 to September 1974 – S&P 500 down 43%
• April 2000 to September 2002 – S&P 500 down 44%

The fact that these losses exist gives the system the risk needed to establish higher expected returns from stocks than from T-bills. The academic term for this extra return is “equity risk premium.” Throughout that same 90-year period, the S&P 500’s annual risk premium over the one-month T-bill is about 8%.

Smaller deficits would create a less risky grading. The price/earnings (P/E) multiple, a common valuation metric, would be driven up and mark a higher expected return.

Embracing the Bear: In Summary

In short, the risk of losses creates the potential to make earnings. Bear markets are necessary for the creation of equity risk premium. For a portfolio to succeed over the long run, one must expect periods of turbulence. Rather than avoiding the market because of its periodic downturns, investors protect themselves by developing smart, long-term investment plans with the inevitability of financial turbulence factored in.

Financial Planning with OptiFour Integrated Wealth Management

If your current plan doesn’t operate this way, it’s time to find a new advisor. Guarantees of a turbulence-free ride without proper protections are unlikely to get you where you want to go. OptiFour Integrated Wealth Management understands the realities of the market and helps clients optimize their portfolios. For more information on our array of financial services, visit our homepage or contact us today.