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Bear Market Survival: A Crash Course From Eric Nelson

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If history is a guide, many investors will miss opportunities waiting for the stock market to crash while others will sell in panic when it finally does crater.

But such portfolio disasters need not happen if investors earnestly do let market history guide them.

The big picture, in other words, should help investors not sweat the small stuff.

To that end, Servo Wealth Management’s big-picture principal, Eric Nelson, takes a look at historical bear markets and recoveries from 1926 till the present, offering lessons that should help investors have an easier time “sticking with [their] plan when everyone else is abandoning theirs,” he writes in a client newsletter.

The first key lesson he draws is that there have been just five severe bear markets for U.S. stocks during this nearly century-long period (1929-32; 1937-41; 1973-74; 2000-02; 2008).

And given that two of them occurred since 2000, recency bias may be inducing greater investor pessimism than the evidence of bear markets’ rarity supports.

A second lesson concerns the magnitude of declines. With one exception, the declines have tracked each other closely, ranging from losses of 32% to 38%. The 1929 market crash was the outlier, with total bear market losses of 64%, but investors should basically expect stock losses in the upper 30s.

By comparing the performance of the S&P 500 with a more diversified stock portfolio containing small and value stocks and with a balanced fund that composed of 65% diversified stocks and 35% 5-year bonds, Nelson can draw other conclusions about the magnitude of portfolio losses.

A small- and value-tilted stock portfolio will not protect investors in a bear-market crash; in three of the five periods, the diversified stock portfolio fared worse, in two it did better.

Only high-quality bonds blunted the bear market’s bite.

“In most cases, the balanced index lost only about half the amount of the overall market and actually produced a reasonable gain during the 2000 decline,” Nelson writes.

Lesson No. 3 for investors is that snapbacks are as violent and unexpected as the crashes.

“Average S&P 500 stock returns in the first few years following a bear market were 50% to 300% higher than their long-term averages of about 10% [a] year, offering a handsome reward for investors who stuck around to see them,” he writes.

Here’s where small and value-tilted portfolios really paid off. While in the most recent market recovery they have only outpaced the S&P 500 by 4% per year; in general they have distanced themselves from the S&P 500 by 8 to 13% in recovery periods.

And how long does it take investors to recoup bear market losses? Lesson No. 4 is that two to four years is the norm. Even amid the Great Depression, investors who held on were whole again by 1936 after the market bottomed in 1932.

Nelson spell out what these facts of market history should teach us. First, bear markets don’t happen frequently enough for market timing. And the risk of stocks’ significant declines is precisely what give them their return advantage over the long term.

Another takeaway is that bear markets are a gift to investors in their accumulation phase, allowing them to supercharge their portfolios when stocks are selling at depressed prices.

For income-dependent retirees, bear markets are to be managed rather than feared, by selling bonds and holding onto stocks to maintain cash flow until stock  prices have recovered.

Nelson says the most important takeaway is the imperative of sticking with one’s plan.

“Recoveries happen so dramatically and unexpectedly , missing even the first few months of a recovery can take years to recoup in more ‘normal’ market periods,” he writes.

In other words, what you’re holding counts for less than simply holding on.