Be Smart Long Before a Market Downturn

04 September 2018

We are now in year 9 of the current bull market, and have seen stock market investments rise by about 400% during that time period (i.e. S&P 500 from the bottom of the bear market in March 2009 to July 2018). Naturally, many people are contemplating how much longer the good times can possibly last, and are wondering what they can do to de-risk or prepare their portfolios for rougher times ahead.

Before I get into it, I want to make clear that this article is not intended to predict the next year or two, but rather to give you a timeless blueprint of steps to take and things to have in place when a downturn inevitably occurs in the future. (If you want to know our current view on the markets specifically, you should check out our latest CIO Insights.)

As we all know, history repeats itself over and over again. We can say with certainty that for every positive bull market, a negative bear market will follow, ever since markets started being tracked. The pattern might not occur in the same way each time, but if you’re an investor in public markets, you need to accept the plain and simple fact that there will come a time when your holdings will suffer for a stretch of time before they move to higher highs.

The good news is that the average bull market lasts much longer than the average bear market. History has told us that on average, a bear market lasts 14 months while the average duration for bull markets lasts 97 months.

S&P500 bull market

So now on to how to prepare in a bull market for an inevitable bear market.

Check the risk profile of your investments

Before you started investing, you might have taken a risk questionnaire or talked to an advisor about different levels of risks you’d be comfortable taking. These results would have taken into account your age, your personal comfort with volatility (the ups and downs of markets), and the timeline for your investment e.g. retirement might be 10 or 30+ years away for you.

There are two major considerations when it comes to determining your risk: first, taking the appropriate level of risk given your investment timeline. For instance, short-term investment goals need less risk associated with them, because if the market were to drop suddenly when you wanted to use the money, you wouldn’t be able to recover the major drawdown that a risky portfolio would have likely experienced in the short term. Risk preferences change as our life stages change. Maybe somebody with a family is a little more risk-averse than she was in her early 20s.

Second, make sure you're taking the appropriate level of risk for your personal risk tolerance. Regularly checking in on your comfort with risk will prepare you for an eventual market downturn and ensure that your hunger for risk doesn’t turn you into your worst enemy. In other words, if you’re bullish in your comfort level with risk, you are likely to be caught by a downturn and make the mistake of selling out of your positions because you realised losses that you weren’t comfortable experiencing in the short term. History has taught us (and it is backed up by scientific research) that a buy-and-hold strategy will almost always beat a market timing one in the long term. So having the right risk for your comfort level in your buy-and-hold strategy is key in setting yourself up for being smart before and in a downturn.

This buy and hold strategy, paired with a dollar-cost averaging strategy will allow you to average down your entry price in “bad times” so that you can enhance your long-term results. In short, your risk level needs to be comfortable enough for you that you’re willing to invest consistently regardless of what is happening in the market.

Set money aside in an emergency fund

Progressing from the first point above, it is of vital importance to have what people in the financial world call an “Emergency Fund” in place. An emergency fund is a safety net for your financial well being. It should be set up before you even start to invest. The usual advice calls for 3-6 months of expenses saved in a very liquid account (cash savings accounts work great). Some people are even more conservative and budget 12 months of expenses in an account. This is highly dependent on your personal situation.

You might ask yourself now what that has to do with an economic downturn? The reason why I am stressing to have one in place is twofold:

  1. In a prolonged economic downturn, the chances are quite high that your company might be suffering (that goes for employees as well as entrepreneurs), and so there is an increased chance that you might lose your job. So having a safety net affords you to remain calm and look for new opportunities without having to worry about how to pay your ongoing bills.
  2. On top of worrying less about how to pay your bills, you will also not be caught having to sell any of your investments (that likely aren’t worth as much as they normally would be) during the downturn, meaning you can ride out the storm without doing damage to your long-term goals.

Adopt a long-term investment mentality

Everyone loves the annual Black Friday sale. There is no better time to buy the things you wanted all year at massive discounts. People will cheer you on for getting a steal on an item and you can be proud of yourself that you waited such a long time to buy the item you wanted on sale. So why do investors not adhere to this common sense? Why do most people freak out when markets turn negative and do the opposite of buying more investments that are now on sale? This phenomenon is called Myopic loss-aversion. In short, it describes that investors make the mistake of thinking short-term for their long-term goals. This short-sightedness results in panic selling at the worst possible time-- when the market drops and everything is cheaper. So don’t sell. But, if you are in a fortunate situation and you still have a job during an economic downturn, take advantage of buying securities at massive discounts.

Set yourself up for success with automation

One of the smartest things you can do is choose a product or platform that allows you to easily set up regular contributions. That way, no matter what the market does, you will always have a standing instruction to invest the same amount of money each month. Robo-advisors, such as StashAway, do just that by automatically investing your funds in personalised portfolios of ETFs (Exchange-traded Funds) no matter what the market does. That way, in the long-term, your purchases average out to buying fair value for those assets. This investment strategy is commonly known as dollar-cost averaging. It’s been proven to get the best return over time, especially compared to timing the market.

It’s not about being a smart investor only in a downturn; it’s about being a smart investor no matter the market conditions. I can’t emphasise enough that a bear market is not avoidable-- eventually, it will happen. Whether that’s 3 months or 3 years away is something that even the most seasoned professional investors can’t tell you for certain. But what I can tell you is that in these good times, you need to make sure you’re mentally and financially prepared for the bad times ahead, as your behaviour when the markets get rocky will have a significant impact on your long-term wealth.

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