CFA, Senior Investment Strategist, Vanguard Investment Strategy Group
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Most adults have seen enough detective movies to know that no 2 fingerprints are alike.
But that fact isn’t obvious to kids. Years ago, after learning in school that each fingerprint is different, my kids spent weeks trying to match their fingerprints to other people. They never came close. While fingerprints share similarities in their makeup,* trying to find 2 identical fingerprints is almost impossible.
Like fingerprints, no 2 bear markets are alike. (In this blog post, we define a bear market as a downturn of 20% or more.) Generally speaking, market downturns appear similar. But when you look at what really happened, each downturn was different, which makes predicting future bear markets difficult (though not quite as tough as trying to match 2 fingerprints).
While all bear markets involve a loss of investor confidence, an assortment of factors can cause them, including, unexpected changes in monetary policy, political events, overvalued stocks (a stock’s current price exceeds its future expected earnings, which increases expectations of a price drop), bank failure, natural disasters and deleveraging(selling assets to have money to pay off debt).
Many of these events are impossible to predict. And even if you can predict them, you can’t always tell how they’ll affect equity markets.
The challenge active fund managers face
Many active fund managers try to look into the future. They choose stocks for their funds by trying to predict which market segments will perform well.
The differences in the last 2 bear markets illustrate how hard it can be to identify which sectors and segments of the market are susceptible to a future downturn.
This style box illustrates that during the bursting of the tech bubble, large growth stocks under performed and mid- and small-value stocks outperformed. During the most recent global financial crisis, large growth stocks performed the best, and large value stocks performed the worst.
Active fund managers’ performance changed too
Active fund managers try to predict which market segments will perform well in the future, but they’re vulnerable to the unpredictability of bear markets too. Success in 1 bear market doesn’t guarantee success in the next.
Top-performing active managers during the bursting of the tech bubble didn’t necessarily stay on top. They were no more likely to stay in the top half during the financial crisis than end up in the bottom half or be liquidated or merged.
We uncovered this information by analyzing all existing funds during the bursting of the tech bubble. First, we bucketed them by performance. Next, we looked at how the top-performing funds fared during the subsequent bear market.**
No 2 bears are alike
Unfortunately, no 1 equity sector or fund style is a guaranteed “safe” choice during the next bear market. However, you can follow universal best practices to increase your chances of investing success under any market conditions.
Determine which investment strategy works for you. Index funds and actively managed funds have unique objectives and benefits. Learn more about index vs. actively managed funds, but keep in mind that index vs.active isn’t an all-or-nothing decision—you can combine fund types within your portfolio.
Choose low-cost funds. Our research shows that low-cost fund managers offer the best chance for success across all situations.
Be patient. Market performance is unpredictable, and you’ll likely feel the effects of volatility whether you invest in index funds or actively managed funds. If you invest in actively managed funds, remember thateven the most successful fund managers go through periods of under performance.
These guidelines don’t guarantee success, but they can put you in a better position to reach your goals—no detective work or finger printing required.
*You can’t prove that no 2 fingerprints aren’t exactly alike because it’s impossible to compare the entire population.
**Funds that were either liquidated or merged during the time period between the 2 bear markets or during the financial crisis fell into the liquidated/merged bucket.
Click here for the original blog article from Vanguard.