As the legendary investor Warren Buffett has sad, “Only when the tide goes out do you see who’s swimming naked.”
February and March 2020 have been a rough few months for investors. The longest bull market in history has come to an end at the hands of a novel coronavirus (COVID-19). On March 16, 2020, the selling of the DOW Jones Industrial Average crescendoed, losing 3,000 points (~13%) in a single trading session. Overall, the stock market has plummeted nearly 30% from recent highs.
Along with trillions of dollars in market gains wiped out, countries and cities have instituted procedures to quarantine individuals in an attempt to delay the spread of the virus. All of this in an attempt to minimize human loss.
Professional sports leagues have suspended seasons. President Donald Trump has issued a State of Emergency and imposed travel bans to and from Europe. Schools and colleges have shut down in an attempt to socially distance their students to help quell the spread. States have begun issuing “stay at home” orders.
Shoppers have left shelves barren in grocery stores, stocking up on canned goods, toilet paper, and hand sanitizer.
While public health is of utmost importance, this pandemic also provides valuable experience for investors attempting to navigate treacherous markets. Hopefully, by the time you’re reading this, markets have rebounded and COVID-19 in the distant rear view mirror.
Now, it’s time to assess what investors can learn from the 2020 Coronavirus Bear Market.
1. Keep Calm, Carry On
Perhaps, the most valuable lesson that can be taught is to stay calm. However, staying calm when your life savings drop 30% in a matter of weeks is easier said than done, right?
Sometimes, markets decline for good reason. After all, effectively shutting down the US economy for business can cause a self-induced recession in order to save lives.
However, markets are often irrational and uncertainty can cause declines to be amplified. This means even justified declines can be overdone.
This is because markets are driven investors’ emotions and feelings about the future. By their very nature, people are emotional beings. When it comes to our hard-earned dollars, our feelings are magnified. We feel the pain of loss more strongly than the joy of gain. This is a behavioral economics theory called Loss Aversion.
Anytime there is mass fear and panic (even when a level of concern is necessary), making major changes in investment strategy in the midst of uncertainty is rarely the right answer.
Instead, consider where you think the market will be in 3-5 years. More than likely, any event that causes a 20%+ decline in markets will be a blip on the chart. Even the Great Depression is barely noticeable when considering the totality of the market’s return.
Investors should have the mindset that ANTICIPATES market declines
On average, a 10% decline occurs every 1-2 years. Bear markets (20%+ declines) occur every 3-4 years. Often, this provides an opportunity for the market to “reset.”
For those who have planned properly and have a cash pile to invest, this could be a wonderful opportunity to scoop up stocks “on sale” at a substantial discount!
Why wait for a national disaster to strike to think about what you should do in the event markets are in peril? Plan for these declines, and when they happen, STICK WITH THE PLAN that was made during calmer times.
2. Keep PLENTY of Cash on Hand
Nearly half of Americans live paycheck to paycheck.
COVID-19 has upended our way of life, shutting down stores and restaurants. The CDC has recommended Americans limit exposure by postponing large gatherings. All this means is that hourly workers will find it difficult to make ends meet as companies reduce their hours to meet the fall off in demand. For some companies, layoffs may be necessary to reduce overhead and stay in business.
Massive, sudden layoffs can certainly stress our consumerist economy. Ultimately, this could cause an economic recession or prolonged downturn. Clearly, this could put many jobs at risk.
This crisis has taught many to keep their overhead low and keep plenty of cash in the bank.
When there’s a viral outbreak, it could be months before finding another job
After all, if most Americans are working from home and companies are strapped for cash due to the pullback in spending and uncertainty, who would be scheduling interviews in the middle of a health pandemic?
This means you may be need to have plenty of reserves to make it through the turbulence.
Extra cash cushion provides for confidence
Having surplus cash on the sidelines does two things:
- It limits some of the financial anxiety in a time of uncertainty
- Extra cash provides an “opportunity fund” to take advantage of market declines
Before the market crash, I had over 6 months of expenses in my emergency fund. Working in the entertainment industry, I have substantial exposure when events are cancelled and my employer is not bringing in revenue. Obviously, this puts me at particular risk.
While losing my job would be terrible, having cash reserves helps me stay sane during a mentally taxing time.
Extra cash also provides the ability to invest into the bear market
While most are selling stocks, having extra cash provides the ability to buy great companies at a huge discount when the markets around down 30%. Sure, they could continue to fall. However, in 3-5 years, this will probably be an attractive entry price for the long-term.
Even though my portfolio may have taken a painful hit, having cash to invest allows me to reduce my cost basis in my stocks and index funds.
3. Analyze Large Declines to See Which Stocks Perform
Each stock behaves differently.
They all have different characteristics based on the underlying company AND valuation. Some companies may be better insulated. Large, consumer staples and utilities pay high dividends. The demand for their services doesn’t generally vary in a wide range.
After all, people still need their toilet paper and electricity!
By contrast, the business of other companies may be more discretionary. Entertainment companies outperform when the economy is doing well and consumers have more money to spend. When businesses are profitable, they re-invest in themselves. Therefore, technology platforms can sell transformative solutions to their clients.
However, in drastic economic declines, these higher growth companies tend react more violently. In other words, they’re more volatile. When the market drops 10%, these growth-oriented companies may drop 15%-20%+. However, when the market bounces back, they could come roaring back faster than the S&P 500 (as long as they can weather the storm!).
Understand how the current market impacts your holdings
If you purchase individual stocks, document how certain companies hold up. Does your favorite stock outperform during the sell-off? Or does your portfolio fall more than the market overall? Do you have a portion of your portfolio that stabilizes/offsets your more volatile positions?
As broader markets decline, defensive stocks will surely outperform. Weaker or struggling companies in the middle of the blast zone (i.e. airlines, restaurants, hotels, entertainment) may not be guaranteed to survive. Ultimately, many may go bankrupt. Other companies on the periphery will get beaten up. However, when markets recover, they will bounce back.
Viewing how certain stocks perform can help you prepare or re-allocate your portfolio when markets calm down.
4. Diversified Portfolio
Having a diversified portfolio can help cushion the fall.
Ensure your portfolio has a broad mix of allocation
Younger investors may want to be geared towards growth. When the economy is expanding over the decades, this can allow for magnified returns. However, too much “growth” in a portfolio can cause under-performance when markets decline.
When economic recessions inevitably occur, your portfolio could get obliterated.
Having another segment of your portfolio focused on stable, dividend-oriented stocks can help cushion the blow. Sure, they may still decline. However, they probably won’t decline as violently or as far as higher valued growth companies.
These stable, blue-chip companies may be a drag during economic expansions but a lifeline during downturns
Your value-oriented, dividend aristocrat positions in your portfolio could keep you in the investing game until the economy recovers and your other stocks bounce back. Often, these companies may have an inverse correlation to the rest of your portfolio.
If your portfolio drops 40%+, you may find your resilience tested. You may not be as tolerant of the short-term risk as you originally thought. However, having a portion of your portfolio “in the green” can help mitigate other sections of your portfolio experiencing losses.
Further, your blue-chip section could be trimmed with the proceeds used to dollar-cost average down in higher conviction growth-oriented companies. This can help maintain the balance in your asset allocation mix.
After all, when the market declines, your goal is to limit the damage
Since none of us has the ability to predict the future, timing the market can be a futile task.
Selling out into a decline can end up being a costly mistake since we never know when the market has truly bottomed. Those who sell out could end up sitting on the sidelines and never redeploying their cash – even when the market roars back.
However, having a diversified portfolio help you stay invested – no matter the market conditions.
5. Picking the bottom is virtually impossible
By my nature, I’m a contrarian.
When markets were plowing higher, I was a skeptic. While I continued dollar-cost averaging in my 401(k) and making buys in my Roth IRA during the bull run, I began increasing my cash position outside of these accounts as stocks became increasingly pricey from a valuation perspective.
Naturally, when the market began slipping, I started to get excited and put money to work.
Slowly add to positions in increments
Determining when to put money to work can be hard.
During a market sell-off, nobody knows when the bottom will be. It could be down 10%, 20%, 30% or even more. To keep from putting 100% of your cash to work when the market drops 10% and continues to fall, have certain parameters for when you make purchases during a sell-off.
Personally, when the market declines 10%, I began putting cash to work (25%-30%). When the market declines 15%, I add more (another 25%-30%). Finally, when the market declines 20%, I put the remaining cash balance in my portfolio to work.
I am comfortable having all of my investable cash in stocks when the market declines 20% because I have a 30+ year time frame. However, this may not be the case for you. Seek professional advice who can tailor advice to your particular situation.
For me, I know that a Bear Market may continue declining another 10%-15%. However, a 20% decline has historically represented a wonderful buying opportunity for long-term investors.
As I have the cash flow from my salary coming in, I can continue adding to my portfolio on payday during sustained declines.
Continue dollar-cost averaging
For most investors, dollar-cost averaging is the best strategy – especially, in retirement accounts.
Having an automated plan can help you take advantage of market declines and limit mistakes from market timing.
When markets are up, your contribution buys fewer shares of stock or funds. However, when markets decline, your contribution purchases more shares. Over the long-run, these average and help you better track the overall market.
Losing 20%-30% of your Net Worth can be scary
However, remember you haven’t lost money until you sell.
Don’t turn paper losses into actual losses. After all, money that is invested should not be needed for 5+ years. If the market declining 20%+ in a given week, month, or year causes you to lose sleep, you may have money in the market that shouldn’t be invested in the first place.
When markets inevitably recover, you can decide if you need to raise cash and lower your market exposure.
Putting together and following an investing game plan is an important way to navigate tumultuous markets.