It has been more than seven years since the last bear market
began. Stock markets always will—indeed, must—crash from time to time. To see
why, consider the work of the late economist Hyman Minsky. In the 1970s, most
theories held that modern economies were fundamentally stable. Deep recessions
and financial crises were anomalies, caused by outside “shocks” such as bad
policy, war or a spike in oil prices. Mr. Minsky didn’t buy this. Mr. Minsky
believed that a stable economy leads to optimism, optimism leads to excessive
risk-taking, and excessive risk-taking leads to instability. The process
continues until optimistic bankers lend to dubious borrowers who stand no
chance of repaying their debts. That is when the next crisis begins.
The paradox of investing is that if markets never crashed—or
if investors gain the perception that they never crash—stock prices would rise
so high that a new crash becomes nearly certain. Rather than wondering if another bear market
will occur—it will—here are three things investors should do:
Realize what you are
getting into.
The reason stocks have historically returned more than cash
or bonds is specifically because they are volatile, and crash on occasion. Big
volatility doesn’t indicate the market is broken, or that you have been
cheated. It is the price of admission investors must be willing to pay to
achieve returns greater than is offered in less volatile assets.
Assess how much risk
you are willing to take.
Not everyone can handle the stock market’s inevitable
swings, especially if you are in, or nearing, retirement. Balancing a stock
portfolio with bonds can help reduce volatility while still letting you earn a
decent return.
The Vanguard Balanced Index Fund holds 60% of its assets in
a broad basket of U.S. stocks and 40% in a diversified portfolio of U.S. bonds.
The fund returned an average of 6.95% a year for the 10 years ended Dec. 31,
2014, according to Vanguard, while the S&P 500 returned 7.7% annually,
according to data from investment-research firm Morningstar.
The fund lost 36% during the last bear market—from Oct. 9,
2007, to March 9, 2009—compared with a 55% loss for the S&P 500. It charges
annual expenses of 0.24%, or $24 per $10,000 invested.
Learn from your past
behavior.
Rather than trying to estimate how you will react to a big
market drop in the future, assess how you reacted in the past. Past behavior
can be a good indicator of future behavior.
Did you panic and sell when stocks crashed in 2008 and 2009?
Then you probably have a low risk tolerance, regardless of how confident you
feel today. Consider cutting your stock exposure to something less than you had
before the last market crash and raising your allocation to a diverse portfolio
of bonds, or even cash, taking comfort that more of your money is now cushioned
against the inevitable shocks of the stock market.
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