Bear Market Survival Guide
Millions of investors have never experienced anything like the painful stock market slump we’ve seen over the past year. A record-shattering bull market that had endured more than nine years peaked in March 2000.
In the following 12 months, the U.S. stock market fell more than 28%, as measured by the Wilshire 5000 Total Market Index. Some $4.2 trillion in market value evaporated in less than a year. And the decline was not confined
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to the United States—foreign stock markets also fell sharply.
In the midst of the first bear market in a decade, it’s not surprising that many investors are worried and wondering what to do. This Plain Talk bulletin aims to put the market downturn in perspective and offers six common-sense, time-tested guidelines to help investors cope with market volatility.
Six bear market survival tips In 1924, cowboy humorist Will Rogers offered a simple rule for successful investing: “Take all your savings and buy some good stock, and hold it ’til it goes up, then sell it. If it don’t go up, don’t buy it.” Of course, Rogers was joking. Unfortunately, many people think that they can find a method to buy stocks just before they go up, and sell them just before prices fall. But after decades of watching, we have yet to see a timing strategy that has consistently outperformed a buy-and-hold strategy. Even if timing strategies were found to work “on paper,” the real-world costs of trading and taxes would almost surely doom them to subpar results. But if “avoid downturns” isn’t the answer, what should investors do? These six basic guidelines can help you continue toward your long-term investment goals, come bear or bull market.
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guidance on carrying it out, it’s likely that you are “the leading expert” when it comes to your own finances and temperament.
Don’t act impulsively. It’s natural—even for experienced investors—to become nervous when account balances are falling along with the financial markets. The urge to change your investment mix can be powerful, especially when a downturn gets worse and news gets grimmer. But impulse and emotion are enemies, and it pays to resist them. This is true not only in bear markets but also in bull markets, when euphoria can tempt you to “double up” on your holdings that are performing best. For example, during the latter stages of the 1990s bull market, many investors switched from lagging market sectors (bonds and value stocks) into soaring technology stocks. The switch proved very costly as technology stocks plunged.
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Keep your balance. How badly has the bear market mauled your portfolio? That probably depends on the extent to which you had diversified your holdings. Fooled by the unusual length of time that large-cap growth and technology stocks had led the market, some pundits were saying that the “new economy” had made diversification an obsolete idea. But then technology stocks abruptly changed from leader to laggard—an event that has occurred across all sectors many times in the past, as shown below.
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Follow your plan, not the herd.
Past Performance Is No Guarantee—Really!
Savvy investors understand that returns from stocks and bonds constantly fluctuate and that these ups and downs will sometimes be extreme and lengthy. The key is not to avoid downturns (see tip #1) but rather to prepare for them by selecting a mix of stocks, bonds, and cash investments that makes sense for your situation. Your plan should be based on such basic but unique variables as your investment time horizon, your objective, the security of your income, the extent of your resources, and your tolerance for market fluctuations. And while you may want to seek an expert second opinion on your plan or some
Rank Among Market Sectors Based on Total Returns Economic Sector ‘85–’87 ‘88–’90 ‘91–’93 ‘94–’96 ‘97–’99 ‘00–’01* Consumer Staples 1 2 8 6 6 6 Basic Materials 2 10 6 7 11 8 Health Care 3 1 10 2 4 4 Communication Svcs. 4 3 7 8 2 10 Utilities 5 5 9 10 10 1 Consumer Cyclicals 6 8 2 11 3 9 Capital Goods 7 6 5 4 5 7 Energy 8 4 11 5 8 2 Financial Services 9 9 1 3 7 3 Technology 10 11 4 1 1 11 Transportation 11 7 3 9 9 5 *Through March 31, 2001 Sources: The Vanguard Group, Wilshire Associates Inc.
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Perhaps the single biggest lesson from the 2000 –2001 downturn is that diversification—the simple concept of not putting all your eggs in one basket—is still an investment virtue. That means diversifying across asset classes—stocks, bonds, and cash—but also within asset classes. Include both growth and value stocks, as well as large-, mid-, and small-capitalization companies in your portfolio.
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Continue your investment program. Most investors build wealth systematically through regular investments, perhaps by payroll deductions for a retirement plan at work or through an automatic investment program. This systematic approach— known as dollar-cost averaging—can help you to put the market’s fluctuations to work for you by lowering the average price you pay for fund shares. And it can be a disciplined way to keep emotion from altering your plan. Clearly, dollar-cost averaging cannot guarantee you a profit on your investment or protect you against losses when stock or bond prices are falling. And dollar-cost averaging is unlikely to work for you if you are unwilling or unable to continue investing during a long downturn in the markets. After all, to earn the stock market’s 15.0% annual average return over the past 20 years, an investor had to stay invested in stocks through two earlier bear markets—including the October 1987 crash and the 20% decline from July to October 1990, a period spanning Iraq’s invasion of Kuwait.
Total Return
Diversify to Manage Risk 0% –5 –10 –15 –20 –25 –30 –35 –40 –45
60% Stocks/ 40% Bonds
Broad Stock Market
Growth Stocks
–11.2%
–24.8%
–42.5%
This chart compares the total returns from March 31, 2000, through March 31, 2001, of three hypothetical asset mixes: (1) 60% Wilshire 5000 Total Market Index (the entire U.S. stock market)/40% Lehman Brothers Aggregate Bond Index (representing the total market of U.S. bonds with maturities over one year); (2) 100% Wilshire 5000 Index; and (3) 100% Russell 3000 Growth Index (the growth stocks among the 3,000 largest U.S. stocks). By ensuring that your portfolio is balanced and broadly diversified, you won’t escape damage during a bear market, but you may avoid a catastrophic decline. Note that past returns are not an indication of future returns.
Moreover, by investing in mutual funds rather than individual securities, most investors have been better able to manage risk through diversification. Research by Morningstar, a mutual fund tracking company, shows that nearly one in every three U.S. stocks lost 20% or more of its value in 1999. Yet fewer than one in every 400 U.S. mutual funds lost that much over the same time period.
A way to make up lost ground If you think the bear market is endangering your chance to meet your investment goals, you may want to boost your savings. No one can change the past or future returns from the financial markets, but you may be able to increase how much you’re investing.
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Make any portfolio changes gradually. If the bear market has convinced you that your tolerance for the volatility of stocks is less than you once thought, or if you’re simply frightened, you may want to “sell down to the sleeping point.” But Vanguard suggests that you act in a measured way. Change your long-term investment portfolio gradually, and resist the urge to make drastic changes. This reduces the chance that emotions are overriding a sound plan. Consider a limit of no more than 15% in changes to your allocations. For example, if your asset mix had been 70% stocks/ 30% bonds, you might gradually move toward a mix of 55% stocks/45% bonds.
No bear for bonds Despite the bear market for stocks, bonds have been in a bull market. In the 12 months ended March 31, 2001, the bond market returned 12.5%, as measured by the Lehman Brothers Aggregate Bond Index. Bond prices move in the opposite direction from interest rates, so as interest rates declined amid a slowing economy, bond prices rose. Money market investments also have provided solid returns amid the stock market slide: The Salomon Smith Barney 3-Month Treasury Bill Index earned 6.0% during the 12 months ended March 31, 2001. 3
Online help for bear market survivors
Cheaper may not be cheap Hundreds of individual stocks—and the market as a whole—are much cheaper now than a year ago. However, that doesn’t necessarily mean they’re bargains. Before the downturn, stock prices had risen to unprecedented heights compared with such fundamentals as earnings, dividends, and book value. Despite steep declines, price/earnings ratios and other valuation measures for the overall market are still above long-term norms.
Has the recent real-world “stress test” given you the sinking feeling that your risk tolerance isn’t as high as you thought? Find out if your
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Tune out noise.
investment program matches your needs by
Ever felt dazed by the volume of facts, opinions, and statistics about the markets and investing? You’re not alone. Unprecedented amounts of information— in print, via broadcast and cable, and over the Internet—flow to investors, including minute-byminute accounts of every day’s doings in the financial markets. Unfortunately, the overwhelming focus is on short-term events and forecasts, which amount, in the end, to little more than noise. More information available in more ways can be a good thing. But the risk is giving in to the natural itch to react to all the information—to do something with it. Successful investors are able to tune out the noise and keep their focus on their long-term investment goals and plans. This isn’t easy, especially when markets are soaring or slumping, and the Internet enables you to check your account balances by the hour. But changing course with each new piece of information or commentary is unlikely to get you to your destination.
taking Vanguard’s Investor Questionnaire at
www.vanguard.com/?planning. Simply answer a few questions about your investment objectives and experience, time horizon, risk tolerance, and personal situation; the questionnaire will help you reassess your asset allocation—and even give you fund suggestions. Or speak with one of our skilled
Make a plan; stick to it
associates at 1-800-662-7447.
www.vanguard.com
As the past few years have shown, financial markets are fickle and unpredictable. But your investing strategy should be reasoned and steadfast. Once you’ve built a plan that makes sense for your situation and rests on the reasonable assumption that markets will go through periodic ups and downs, you’re in a position to stick with it, come what may.
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The bear in perspective The 2000–2001 decline was the worst since 1987, when broad market indexes fell 33% from August to early December. However, the bulk of that drop occurred on one day: the record –22% crash on October 19, 1987. Though severe, the 1987 downturn was brief—about three months from start to finish.
Just what is a bear market? A bear market is Wall Street jargon for a sharp decline in prices. There’s no official definition, but a bear market for stocks generally is defined as a decline of 20% or more in broad market indexes over at least a two-month period. (A bull market refers to a prolonged period of rising prices.)
By contrast, the bear market that began in March 2000 has stretched for 12 months so far. Although it has been punctuated by a number of strong interim rallies, the downtrend has been persistent.
Despite the market’s slump, the economy has not yet fallen into a recession—when economic output and employment fall. The Federal Reserve Board has been aggressively lowering interest rates in an effort to ward off a recession. Statistical data available through March 2001 point more to a sluggish economy than to a shrinking one.
One striking aspect of the 2000–2001 downturn is the uneven nature of the damage. The worst carnage occurred in technology, the best performing sector in 1999 and early 2000. The Nasdaq Composite Index, which is dominated by large tech stocks, gained 87.4% in 1999 en route to an all-time high of 5049 in March 2000. But all those gains and more were lost as the index fell 64% from that peak to 1830 one year later.
Longer-term returns still solid Despite the past year’s losses, longer-term results from the stock market have been quite good by historical standards. As bad as the 2000–2001 decline has been, those who’ve been in the stock market for five years or more probably have achieved sizable gains, thanks to the extraordinarily bountiful years preceding the downturn.
Yet while dozens of formerly high-flying stocks from the tech sector have been savaged by losses of 75% to 90%, a number of stocks that had lagged far behind in 1999 and early 2000 have enjoyed solid gains since then.
As the adjacent table shows, the average annual total return of the Wilshire 5000 Index for the past 5 to 20 years has been well above the 11% average annual return from stocks over the past 75 years.
No “new era” In part, the uneven impact of the bear market reflects the extremes of valuations for stocks in early 2000, when talk of a “new era” for stocks was rampant. Many large technology stocks were selling for more than 100 times earnings from the previous year, and many new Internet-related companies had huge market values even though the companies were posting big losses. At the time, skeptics’ warnings that the stocks were wildly overvalued fell largely on deaf ears; in retrospect, it’s clear they were right.
Returns From the U.S. Stock Market* Periods Ended March 31, 2001
But the stock market downturn also reflected a general slowing in the economy during 2000. This slowdown made it plain that corporate earnings could not grow at anything like the rapid rates needed to justify the high prices for many large tech stocks. Indeed, in short order many companies were warning that their earnings would decline. As the market euphoria ended, many dot-com stocks were doomed—their operations were unprofitable, and investors declined to keep pumping cash into them.
1 Year
–19.1%
3 Years
3.8
5 Years
14.2
10 Years
14.8
15 Years
14.2
20 Years
15.0
*As measured by the Wilshire 5000 Total Market Index.
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