Since the S&P 500 hit a low of 2,305 on March 16, 2020, the stock market sprang back strong, finishing 2020 with a more than 16% gain. Despite a shaky first month of the new year, it’s still well above its pre-pandemic high of 3,380 on February 10 of last year. Some say we’re in a “secular” bull market—that the severe downturn in last year’s first quarter didn’t count as a bear market because it was caused by factors not related to the economy.
But just as surely as nighttime follows daytime, true bear markets follow bull markets. The only questions are, “When?” and “Are you ready?”
No one knows the answer to the first question. The good times could go on for a while, or they could end today. As for the second one, ideally your answer would be, “Yes.”
But what does it mean to be ready for a bear market?
Managing expectations
Most of us find it very difficult to envision the future. And we feel the pain of loss much more acutely than the pleasure of a similar gain. That’s why, when things suddenly turn bleak in the stock market, many people get scared and sell.
Here’s the problem with that. If fear drives you out of the market, fear will tend to keep you out of the market through much of the recovery that follows.
Before the last bear market, 65% of people owned stock, either directly or through mutual funds, according to Gallup. Today, that figure is 55%.
It’s often only at the very end of a bull market that investors who have been on the sidelines get back in.
Fear drives many people out. Fear of missing out draws many people back in.
There’s a better way.
It’s all about process
The longer I’ve studied investing, and of course, the longer I’ve actually invested, the more convinced I’ve become that success is not about choosing the right investments, and it’s definitely not about market timing. It’s about choosing the right investment process.
Here are the key criteria for a good investment process:
- It’s objective and rules-based. Don’t invest based on a money manager’s predictions about the future, your gut feel about a particular investment, or because everyone’s pouring money into the investment-of-the-moment. Instead, use an investment process that’s based on clear, unbiased, mechanical rules that point you to specific investments and tell you if and when it’s time to sell those investments and replace them with something else.
- You fully understand and agree with its design. You should be able to explain to a teenager how the process works and why you believe in it.
- It has a demonstrated track record of success. That doesn’t mean year-after-year of double-digit returns. No investment process can promise that. But over a more reasonable, longer time frame, it should have a track record of delivering a sufficient enough average annual return to meet your investing objectives.
- It’s emotionally acceptable to you. That means you’re comfortable taking whatever steps are necessary to execute the strategy. And it means you have a sense as to how volatile the approach may be and you are willing to stay with it in up markets and down markets.
If you’re using an investment process that meets those standards, you can confidently ignore the headlines about this year’s “can’t miss” investments, your co-worker’s latest hot tip, and the headline about WallStreetBets. And you’ll be in the best position to weather market downturns without succumbing to fear.
Is there a process behind your investment decisions? Does it meet the criteria described above? Next week, I’ll give some examples of investing processes that do.
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