Bear Markets and the Danger of “Safe” Investing

March 9th, 2017 marked an interesting anniversary in the world of investing.  On this date, we celebrated the eight year anniversary of the current bull market which as of this writing, remains intact. It is the second longest bull market in history (the longest being October 1990 to March 2000) and during this period the US stock market (S&P 500) has returned over 250%!

What’s interesting is just how fearful the investing world seems to be given the crazy news cycle marked by Trump’s latest tweets, constant political wrangling, North Korean missile tests and a Russian conspiracy de jour.    Mix in above average stock valuations (relative to history) and it’s no surprise that we are hearing more and more of our clients indicating they want “safe” investments for what they think will most certainly be a market crash. market-correction-bear

Now we have long believed and written many times that we don’t know what the stock market will do in the next few days, weeks or months.  What we do know is that bull markets do inevitably end, and yes, there will be a bear market (defined as a 20% decline in stocks) again at some point.  We just don’t know exactly when this will happen, when it will end and when we should re-enter the market.

However, we do know that when bear markets do end (with an average return to prior levels of about 3.3 years), it’s best to be invested in order to take advantage of what is typically a strong rebound.

But herein lies the conundrum, if we know a bear market is coming, shouldn’t we invest our portfolio in “safe” assets like 100% bonds?   Quite simply:  No- not if we are investing for the long term.

The reason for this is, as indicated by the oxymoronic title of this blog post, it can be very dangerous to be safe when investing over a long period of time.  By forgoing risk and accepting “safe” returns from say a 100% bond portfolio, we are ironically, taking on even MORE risk by sacrificing the underappreciated magic of compounding returns over the long term.

To illustrate this, we have designed a draconian scenario comparing two basic investment portfolios over a 20 year period.

Here is the scenario:  A 45 year old couple starts with a healthy $750,000 portfolio and wants to retire at age 65 with $3,000,000.  They commit to contributing $15,000 per year to their portfolio.  Since they think we’re going to have a bear market soon, they are concerned they won’t reach their goal.  So in our simplistic scenario, they have two choices The “Safe” Portfolio and the “Dangerous” Portfolio.  Let’s define each:

The “Safe” Portfolio:  100% bonds, comprised of 50% short term US government bonds and 50% intermediate term US government bonds.  The starting point is $750,000 and the investor contributes $15,000 per year as they save for retirement over 20 years.  For annual growth, we will assume historical returns (from 1926 – 2016) of 4.31% per year.

The “Dangerous” Portfolio:  60% stocks (60% large cap US, 20% small cap US, 20% international) and 40% bonds (50% short term US government bonds and 50% intermediate term US government bonds). Again, the starting point is $750,000 and the couple contributes $15,000 per year.  Annual growth in this portfolio is assumed to be the historical growth rate of 8.74%.

The “Bear Markets”:  As you would expect, without the stomach-churning bear markets the higher returning portfolio with stocks will be much higher after 20 years of compounding.  But what if we added two loud and nasty “growls” from the Bear?  What if we added a bear market of a 20% stock market decline (0% decline for the “Safe” portfolio and a 12% decline for the “Dangerous” portfolio) in Year 2 and then another awful bear market in Year 16?  For this awful Bear in Year 16, we’ll assume a repeat of the historically worst annual return of each portfolio in the last 50 years.  For the 100% bond portfolio, it’s a 1.15% decline- not bad at all.  For the “Dangerous” Portfolio it’s a 20% decline- ouch!

The Result:  What might be surprising to some, is that even with two terrible bear markets, the “Dangerous” Portfolio far out performs the “Safe” Portfolio.  Looking at the chart below, we see that our retirement saving couple will NOT reach their goal of a $3,000,000 portfolio in retirement because their “safety” cost them dearly.  In fact, the difference between these portfolios is $935,000 with the “Safe” Portfolio at $2.027 million and the “Dangerous” Portfolio at $2.963 million!  That is VERY expensive safety!!!

safe investing

Now we must temper our conclusions with a few “real world” factors.  First, as our couple moves closer to retirement we would certainly monitor and modify the allocation to align with their retirement date.  Second, we would also implement “psychological firewalls” to help keep the couple fully invested in a growth portfolio.  This typically includes a tailored portfolio of individual high quality bonds, providing assurance of cash flow as retirement approaches.  Third, in order to keep this simple, this scenario does not assume systematic re-balancing of the portfolio, which we also execute for clients.

But the bottom line is this:  No one really knows when the next bear market is coming even though we all know the next bear market IS coming.  But even if it comes in 2018 and even if there’s a worse decline 5 years before retirement (in this scenario), it is still much more beneficial to stay vigilant about keeping a balanced portfolio.  Because the irony is, our attempts to keep a safe & conservative portfolio actually results in taking on much more risk that we thought.  In this case, the “price” for this risk is almost $1,000,000!

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