In Part 2 of our new video series Conquer Your Fear of the Stock Market, produced by Regis Media for RockWealth, established that market crashes are very rare and that most market downturns are just corrections and not the start of a full-blown bear market.
But there’s no escaping the fact that crashes do occur — and that predicting when they’re about to happen with any accuracy is extremely difficult.
In Part 3 we take a closer look at bear markets, how severe they can be, and what you can do to prepare for them.
Transcript for Part 3 of Conquer Your Fear of the Stock Market:
3. Bear markets are part of a normal market cycle
So, we’ve established that market crashes are very rare and that most market downturns are just corrections.
But there’s no escaping the fact that crashes do occur — and that predicting when they’re about to happen with any accuracy is extremely difficult.
Professor Jens Hagendorff from University of Edinburgh Business School says: “It is more or less inevitable. And the reason that it’s inevitable is because prices are determined by new information, the economic cycle is a big part of what generates that new information – the economy might be doing better than expected, prices go up; the economy might be doing more poorly than expected, stock prices will go down.
“So as long as the profits of companies fluctuate, as long as there’s uncertainty in this world, we will see some form of cycle. So, only in a world without any uncertainty – where the profits of companies are entirely predictable, and the jobs of people are entirely predictable, will we see no bear markets. I’d say that’s a very unrealistic view of the world; it’s probably also not a very enjoyable world to live in, if there’s no risk. Stocks are risky assets: they’re volatile, that’s the definition essentially of risk. And it is that riskiness that means we earn, as investors, a higher return on stocks than we do on other less risky assets.”
Professor Janette Rutterford from the Open University Business School says: “There’s been a lot of work done on over-enthusiasm. The idea being that share prices react more than they should do given what the news is that’s changed the price.
“So, for example, they go up more than you’d expect, and they go down more than you’d expect. People tie that in with investor behaviour: things like herd behaviour – that if markets are going up, you want to be in there, and so you join and of course it all ends in tears. And similarly, you think you should start selling when things are going badly. And so people exacerbate the market movements themselves, and that’s really sort of behavioural. I can’t see, however much you tell people that’s the case, it doesn’t seem to stop them doing it.
How severe, then, can crashes and bear markets be?
On the face of it: very severe.
For example, between December 1999 and March 2003, the FTSE 100 fell more than 50%.
Between October 2007 and March 2009, the FTSE 100 fell nearly 48%.
But figures like those can be misleading. No-one invests all their money in the FTSE 100, or at least they shouldn’t. Having a diversified portfolio, and one which includes safer assets such as government bonds, will reduce the impact of a crash substantially.
To demonstrate what we mean, we’ve put together a balanced and diversified portfolio containing a 40% exposure to bonds and a 6% exposure to property. The remaining 54% of the portfolio is allocated to equities.
We’ve applied an annual fee of 26 basis points, or 0.26%, and assumed that the portfolio is rebalanced to restore the original asset allocation every year.
Say you had held this portfolio throughout each of the bear markets referred to earlier. Instead of falling nearly 48% between October 2007 and March 2009, the portfolio would have fallen by a much more modest 8.11 per cent. In fact, you would only have had to wait for two months from the lowest point on the 9th of March to be back to where you were when markets started falling 18 months earlier.
And what about that earlier bear market? Well, instead of falling 50 per cent between December 1999 and March 2003, the portfolio would actually have risen 1.72 per cent.
So what does all this mean for investors? First of all, diversify. Don’t try to pre-empt a bear market and miss out, potentially, on many years of positive returns. And don’t be tempted to change your asset allocation once markets have fallen sharply.
Instead, simply carry on investing as normal and rebalancing your portfolio every year.
Remember, bear markets become bull markets. In fact once the bottom is reached, prices can rise very sharply.
Professor Hagendorff says: “Markets can rise very quickly again when the optimism returns. Traders often use this rule of thumb that, something like 10 trading days make up half of your returns on the way up. So you miss any of them – or most of them or, god beware, all of them – you will be seriously at a loss to other investors who have not left the market. So, markets are very quick to adjust to new information.
“That is why volatility exists in markets — they react to good news and bad news; and that reaction, overall, is pretty fast. So if you’re not already in the market when the new information is priced in, you won’t be able to join in afterwards and benefit from that new information.”
Crashes, then, should be seen as part of the normal ebbs and flows of equity markets.
It’s very hard to avoid them and you shouldn’t even try. Instead, just lengthen your time horizon and try to capture long-term market returns.
Professor Russell Napier runs a financial history library in Edinburgh called The Library of Mistakes.
Professor Napier says: “People sometimes ask me, “What is the number one book to read on finance?” And it’s a book by Elroy Dimson, Marsh and Staunton called Triumph of the Optimists. It’s a road map of the historical returns from equities, bonds and cash over a very prolonged period of time. And it allows you to work out what has been a reasonable return and an unreasonable return — in other words, what you can expect from a market and what you can’t expect from a market.
“I think the simple answer from all of that data is that you do need to diversify, as a layman. And not just between equity markets, but between asset classes.”
So, don’t try to be clever. Timing the market is very hard and usually self-defeating. It’s time in the market that really counts.
Picture: Mark Basarab via Unsplash
Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.
