Bear markets can have a positive side

One thing we know about the financial markets is that they are, by definition, volatile. Ironically, it is this volatility that is a necessary element for the higher returns historically provided by stocks. This year the stock market is down in what is known as a bear market. A bear market is one in which the market declines by at least 20%. While bear markets can be difficult to live through, there are a number of reasons why they can be looked at from a positive point of view.

The financial markets are driven by a combination of quantifiable and non-quantifiable elements. The quantifiable elements include things like assessments of the economy, interest rates, government and Federal Reserve policy, corporate profits, and geopolitical factors. The non-quantifiable components include things such as investor emotions (referred to as investor “sentiment”) or assessments of geopolitical risks. Both quantifiable and non-quantifiable factors can have a significant effect on valuation, or the amount investors will pay for a company’s stock or bond. In a bear market, investors bid down (or pay less) for stock prices because of concerns over things like the factors mentioned above. This year, the key factors of concern for investors have been high inflation, Federal Reserve interest rate policies, economic slowdown, and geopolitical events such as the war in Ukraine.

Bear markets should not necessarily be feared. Bear markets occur, on average about every four years and average about ten months in duration. A couple of key things to note about bear markets is that, like market “corrections” (downward moves of 10-20%), they are part of the normal rhythm of the financial markets and they can actually be beneficial for the markets. And the good news is their impact on portfolios can be planned for and mitigated. It’s important to note that bear markets can be beneficial because they help to dampen or wring out excesses in the markets that can lead to excessive risk or inappropriate allocation of capital. They also help to keep investor sentiment from becoming too extreme.

As financial planners, we can plan for bear markets and implement strategies that can lessen their impact on client portfolios. One of the ways we can reduce the impact of a bear market on client portfolios is through asset class diversification. This involves holding investments in several asset classes such as stocks, bonds, commodities, and real estate. Holding multiple asset classes helps to reduce portfolio volatility by offsetting or lessening the impact of a material decline in one asset class. The allocation of a client portfolio among the asset classes can also help to mitigate the impact of a bear market by reducing weightings to more volatile asset classes. An appropriate allocation for a client is determined from the client’s financial plan and then implemented within their investments. Normally, a higher allocation to bonds or fixed income should result in lower portfolio volatility as bond prices tend to be less volatile than stocks during periods of market stress.

Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.