January 2012: Investing in a Bear Market

Dear Clients and Friends,

I hope you enjoyed a festive Holiday season!  Now that the wrapping paper is thrown away, the food is eaten and the dieting starts, my favorite time of year begins.  It's "Prediction Season" in the financial press.  No doubt you will hear breathless pundits talking about where the market is going, what the Dow will be in 2013, and if American Idol will be around for another year.  There are a couple ways to go when making predictions.  One philosophy is:

"If you are going to make predictions... predict often." - Anonymous

I'm more of this philosophy:

" Prediction is very difficult, especially about the future." - Niels Bohr  Danish physicist (1885 - 1962)

Given our current environment, I couldn't help but notice a variety of doom and gloom predictions that are floating around right now.  Which brings me to the topic of my current letter...

Investing in a Bear Market(Or: Learn to Love the Bear)

Several pundits - and even a few people whose insight I actually value - are seriously concerned that we are in the midst of a "Secular Bear" market.  Secular means long, sometimes really long.  Being a former engineer, when faced with such claims, I like to go to the data.  Here's an interesting little chart put together by Doug Short at Advisor Perspectives (dshort.com) that illustrates the inflation adjusted trends for the S&P index:

This chart illustrates the major bull (positive) and bear (negative) phases of the market.  Now different people would look at our current timing on this chart and interpret it different ways.  Some might say this shows that we are in the middle of a bear market that started in 2000 and we are only half way through.  Others might say we are at the beginning of a bull market that started in 2009.  Just remember, when you hear predictions from people that think they know - they are probably interpreting data that's not too different from the chart above.  If you want to talk about the bull-bear phases in detail, feel free to give me a ring.

I'd like to discuss the implications if we are in a bear market right now.  Bear markets are bad, right?  We should just probably pack up our bags and go home, right?  Well, as it turns out, for Bootstrap Capital clients, a bear market would be a good thing.

I can hear what you are thinking, "What the... what the... What?"  Like many things in investing this concept is somewhat counter intuitive.  It turns out, that if you do the math (which I did) most investors would be better off with flat or declining markets followed by a bull market near or during retirement.  This is because it gives us a chance to purchase assets (stocks) cheap and then sell them later when they are more expensive.

To illustrate this we'll walk through a mental exercise (NOTE: this is a theoretical exercise and is not meant to reflect any actual prediction for future stock returns).  Let's consider the fate of Sally Saver, our fictional investor.  Sally is young and she has committed to saving $10,000 per year in her 401(k) for an anticipated 30 years.  For simplicity she is investing in the US stock market.  Over the long term, the return on US stocks has been around 10%.  Let's consider the following potential scenarios:

Scenario 1: Stocks return 10% per year for 30 years - about their historical long term average.

Scenario 2: Stocks return 10% on AVERAGE for 30 years.  But this is composed of a 10 year Bear market returning only 4% per year (roughly in line with inflation), followed by a 20 year Bull market that returns 12.8% per year.  This scenario is similar to some of the historical periods illustrated above.

Under which scenario is Sally better off?  Scenario 2, of course, you guessed it already.  I gave away the answer in advance.  But you might not have guessed how much better off.  In Scenario 1 Sally saves a cool $1.8 million.  But in Scenario 2, Sally saves $2.4 million!  That's 33% better return for having saved diligently through a bear market!  The 10 year bear market allowed Sally to buy more shares at depressed prices.  This turbo charged her portfolio growth in the Bull market years.  Although the 30 year Bull market would definitely feel better, it would leave you financially worse off.

As is often the case, investing is a matter of discipline and conviction as opposed to intellectual horsepower.  There is nothing easy or pleasant about continuing to invest in down markets.  Putting money to work every year while seeing markets go down can be psychologically tough.  And I'm sure my little example has not gone and permanently re-wired your brain to take pleasure in declining markets.  But the math is compelling and I hope it helps you stay the course during any tough times we may experience in the future.

If you have any questions about the current investment environment or any of the scenarios discussed in this letter, please don't hesitate to contact me.  Also, if your friends or family have questions about any market or financial issue, please feel free to make an introduction or forward this letter.  We provide Financial Planning and Investment Management services and would be happy to talk with your acquaintances.  We will treat your friends and family with the same care and diligence that we treat you.

Thanks,

Brian McCann