While there is no official definition, a bear market has traditionally been defined as a 20% decline in a broad stock market index. Needless to say, bear markets can be horrifying. Not only because of the pain of seeing account balances go lower and lower, but because bear markets are often accompanied by a general sense of panic and media speculation about the coming end of world. But many successful investors take a different view of bear markets and stock market volatility in general–as the price they are willing and must pay to enjoy the higher returns that come with stock ownership.
First, it is useful to think about exactly what we are buying when we buy a stock. Unlike a CD or a bond, a stock offers no regularly scheduled interest payments and no promises to repay at a specific maturity date. Instead, you are purchasing a share in a company’s future earnings, and these earnings, by their very nature, are highly uncertain and far out into the future. As a result, the price of a stock is very sensitive to even small changes in the outlook for future earnings. It is this uncertainty that is the source of the volatility we see in stocks.
So why in the world would anyone want to own stocks? Well, no one would, if it wasn’t for one important thing. While there are no guarantees, investors can reasonably expect to get paid a higher return over time for owning stocks than they are likely to get from owning a bank CD or a Treasury bond. The higher return is compensation for taking on the additional risk, volatility and uncertainty of owning stocks. Take away that risk, and you take away those potentially higher returns.
To illustrate this idea, let’s examine the period from 1946 until the end of 2013. During that time, there were 13 horrifying bear markets when the S&P 500 declined 20% or more from peak –to- trough. The average bear market lasted a little more than a year, and the average decline was approximately 31%. In other words, every five years, investors in US stocks lost about one-third of their capital. And on three occasions, investors lost about half of their capital (Source: http://politicalcalculations.blogspot.com/).
On the flipside, during that same time period, dividends paid by US stocks increased by a factor of 50, their earnings increased by a factor of 100, and the level of the S&P 500 index went from 18 to 1800. Furthermore, the total return (with full dividend reinvestment and assuming taxes were paid from other sources) was 10.7% annualized, which over a 68 year period means that a $1,000 investment would turn into $1,000,000. Meanwhile, the return of one-month treasury bills was 4.2%, barely outpacing inflation (Source: http://politicalcalculations.blogspot.com/).
Now that doesn’t mean everyone should go ahead and put 100% of their investable assets in stocks. Investors that have a short time horizon may not have enough time to withstand a bear market decline if they own a portfolio that is invested predominantly in equities. In that case, a more suitable portfolio might be one that is more heavily weighted toward fixed income investments. Ultimately, it comes down to having a well thought out plan that takes into account time horizon and a host of other factors.
The bottom line is that risk and return is a package deal. Recognizing that bear markets are the price investors pay for higher long term returns can make the difference between successfully staying the course, and abandoning an investment plan at exactly the worst time.