by Donald Gould
The question below was posed to Don Gould through Investopedia’s Advisor Insights program. Investopedia.com is a leading provider of online financial educational content and their Advisor Insights program allows investors to post questions to top advisors on a variety of personal finance and investing topics. We will periodically post Don’s responses to some of these questions when we feel they are helpful and of interest to clients and blog subscribers. You can “follow” Don on Investopedia’s website by clicking here.
Question: Where do investors tend to put their money in a bear market?
This question looks simple, but on further inspection, it’s what a trial lawyer might call a “leading question.” As discussed below, it leads to unfounded assumptions about the basic nature of markets.
Let’s start with a few unpleasant facts.
At any point in time, you never know if you are in a bear market, so the question itself is based on the false premise that you do. A bear market—commonly defined as a period in which a given stock index has dropped at least 20% from a peak—can only be identified after the fact. Until the market has dropped 20% from a peak, you are not yet in a bear market. Once it’s dropped 20%, you can say that you were in a bear market, but you still have no idea where the market’s going next or if you are in what will later be viewed as a bear market. Every uptick is potentially the end of a bear market and the beginning of a new bull market.
Consequently, advice about what to do during a bear market is really a fantasy that can only be enjoyed with the benefit of hindsight. Unfortunately, we can’t invest with hindsight. I’m fond of saying, if I knew where the market was going next, I wouldn’t have to provide investment advice for a living.
If stock prices have recently fallen by 20% (or any amount), that information contains absolutely zero predictive value of where they are going next.
Falling stock prices do not, in themselves, tell you anything about how money is moving between, say, stocks and bonds. It is not necessary for even a single share of stock to be bought/sold in order for a stock’s price to fall. The lower price simply means that the equilibrium price (the price at which buyers and sellers are willing to transact) has changed. This happens all the time when a company halts trading in its stock and then makes a major announcement. If the announcement is good (bad) news, the price adjusts upward (downward) without any trades in the stock having taken place.
Market observers are fond of looking at a downward sloping historical stock index chart and saying “the market is going down” or “we are in a bear market.” The truth is, the only thing you can say with certainty is that the market has gone down and perhaps we were in a bear market. Where it is going next or whether we are still in a bear market is anyone’s guess.
There is also a false idea, often promoted by the financial press, that when stock prices are falling, investors are “fleeing” stocks. This is patently absurd. For every seller, there is a buyer. The number of shares owned does not change, only the identities of the owners and the price at which buyers and sellers are willing to transact.
So, to get back to the original question, investors as a group do not tend to do anything in particular in a bear market (except get anxious). And since you can never know if you are in bear market, any advice about what to do during a bear market is nonsensical. The question is a little like asking, when the earthquake comes, what emergency supplies should I buy? The correct answer is, get your supplies in order now, such that when the earthquake comes (the timing of which, like a bear market, is unpredictable), you will be prepared.
The analogous answer in investing is that you prepare for the bear market by making sure in the first place that your asset allocation is consistent with your tolerance for risk. A good financial advisor will make this happen and will also help you stay the course when your stomach least wants to. The advisor will also make sure the portfolio is rebalanced when market ups or downs move it significantly away from its target asset allocation
Unprompted, after a significant decline, most investors do not want to rebalance since it means buying that which has so recently done poorly while selling some of those assets that have held up the best. Even worse, many want to flee to a more conservative strategy to avoid further trauma, failing to consider the seriously negative implications for achieving their long-term financial goals. At these moments of emotion-driven decisions, the advisor should be there to coach the client and help avoid such potentially self-destructive actions.