A “bear market” is defined as a 20% stock market decline. In the last week, the S&P 500 has broken through this level and officially entered a bear market. With this level broken, we are apt to be flooded with doom and gloom and pocketfuls of advice from financial media. However, your strategy for navigating bear markets should be laid out ahead of time and below is a checklist of six items to consider in every bear market.
What should you do in a bear market?
When it comes to your investments: probably nothing. But it’s only human to feel an urge to do something and gain a sense of control in these uncertain times.
While leaving your investment portfolio alone will likely be the best course of action, there are several planning opportunities you can also consider. The common thread among these strategies is they should be identified before the bear market. These are not reactionary decisions made in the heat of the moment, but well-thought-out strategies that may offer a better execution point during a market downturn.
1. Review Your Financial Plan
The importance you assign to investment account balances and performance will often be inflated during bear markets. But you will likely be surprised how little these short-term market fluctuations impact your long-term plan.
Investment performance is just one component of your plan and must be viewed in the context of your time horizon, anticipated spending, other income sources (like social security), total assets (including real estate), and many other factors. If you have built a robust financial plan with your advisor, it will likely take much more than a 20% decline in the stock market to impact your outlook.
And if the market’s decline does impact your plan’s outlook, changing your investments today in an effort to improve returns is unlikely to be the best solution. Adjusting savings, spending, or other (controllable) assumptions is often a better and more realistic path.
2. Rebalance (if necessary)
Review your investment allocations and determine if they have drifted from your investment policy targets. Have your stocks declined significantly while other assets have held steady or even risen in value (like bonds, gold, or commodities)? Then your asset allocation may be out of line with your target allocation and it is time to rebalance.
Your asset allocation and tolerances should be identified in advance -- when times are good. This takes some of the emotion out of your decision to rebalance during a major decline.
2022 is unique to other bear markets we have seen in the last decade because bond markets are also off to a rough start. (And that's a massive understatement. It's the worst start for bonds since 1842!). This means there may not be an opportunity to rebalance if stocks and bonds are your only two major asset classes. But if you have other assets, like gold or commodities, review your target asset allocation ranges and determine whether you are still within your investment policy.
3. Accelerate Planned Savings or Investments
If you have extra cash on hand and your emergency savings is fully funded, consider accelerating your planned savings. Planned savings could include retirement contributions, education savings, or other investments. Your planned savings is specified in your budget. By accelerating your savings, you are not changing the total savings amount for the year. You are pulling forward the timing of your savings or investment.
For example, if you plan to save $6,000 in your IRA through monthly contributions of $500 per month, halfway through the year you would have already saved $3,000 with $3,000 to go. If you have the cash on hand, consider making additional contributions during market declines to take advantage of lower prices.
The same could be applied to college savings, 401(k) contributions, or other investments. If you have a target savings amount for the year and have the cash today, a bear market offers an opportunity to accelerate your savings when prices are depressed.
The below chart shows the annual returns of the S&P 500 Index (gray bars) and the mid-year drawdown experienced in those same calendar years (red dots). For example, in 2020 the S&P 500 declined 34% between February and March, but rebounded and ended the year up +16%. This year the S&P 500 is down 21% through mid-June and has fallen 22% from its high in early January.
Very rarely has the S&P 500 declined more than 20% in a calendar year. And even in years of double-digit declines, the S&P 500 often ends the year substantially higher, and positive. Yes, the market could continue to decline and offer a better buying opportunity in the next few months. But that’s not the long-term trend and these 20%+ declines (fortunately) don’t happen too often.
4. Roth Conversion
If you were planning on making a Roth conversion this tax year, a market correction offers an opportunity to convert your pre-tax assets to tax-free assets at depressed prices. You can effectively convert more shares from pre-tax to tax-free during these market declines at the same tax cost, allowing the assets to rebound after the conversion and lowering your lifetime tax burden on those shares.
Tax considerations should be the leading factor when evaluating Roth conversions, but a market correction offers a great opportunity to accelerate any conversion plans.
5. Sell or Reduce Undesirable Holdings
Bear markets may offer an opportunity to sell concentrated or undesirable positions in your portfolio that you hold due to embedded gains.
For example, you may have an individual stock or fund that has appreciated over several years or decades, with significant taxable gains. Although the position may no longer fit your investment policy or has grown too large, you have been deterred from selling because of the tax burden. A bear market may see this asset decline significantly in value, reducing the embedded gain and tax consequences of selling.
Reducing this position and the reasons for doing so should be identified before the bear market. Accelerating these plans during a decline offers a more tax-efficient opportunity to achieve your objective.
6. Stop Checking Your Accounts
If you have run through this checklist and taken action where appropriate, the final thing to do is stop checking your account balances.
At this point, you have assessed this decline in the context of your overall plan, reviewed your asset allocation, taken opportunities to accelerate savings, completed Roth conversions, and reduced concentrated positions with greater tax efficiency. You have done more than enough.
Easier said than done, but now it’s time to take a break from your investment accounts and check back in a few months (or longer). Then you can run through this checklist again and reassess.
Risk is the Cost of Returns
Unfortunately, these market declines are part of the cost of achieving greater returns over the long run. Bear markets are never comfortable, but hopefully by running through this checklist you can gain some peace of mind that you are planning effectively and doing the right things through these markets.