Why weathering bear markets means lowering the bar

As the reality of stock-market turbulence hits investors, it’s a safe bet that thoughts of crashes, recession, and bear markets will cross their minds. When the market ups give way to the downs, many will wring their hands, knot their eyebrows, and start their mental clenching as they imagine the worst.

But rather than bracing for possible losses, one expert suggests, it might be more productive to embrace them. “[E]ven the Almighty himself wouldn’t be able to time the market deftly enough to enjoy the gains without the pain,” said William Bernstein, investment adviser and author, in a piece for the Wall Street Journal. “[W]hen you invest in stocks, be prepared to occasionally lose a large pile of money.”

The average investor’s strategy, Bernstein noted, appears to consist of pride when prices rise and panic when they fall. To stay the course under dark skies requires a systematic approach, and executing it depends on one’s mindset. That mindset of well-being, he argued, comes from taking reality and subtracting expectations.

“The lower your expectations, the better you will feel when things head south, and the better you feel the more likely it is that you will see your strategy through,” he said.

In the context of portfolio management, he pointed out, that starts with stocks. While investors may be tempted to count stocks as present wealth, especially when markets are doing well, those assets are too prone to heart-stopping falls. The only thing one can say is that they will likely — but not certainly — gain value over time. That means on a day-to-day basis, an investor is better off writing off their stocks.

“The prudent investor mentally writes off a fair chunk of [bonds], too,” he continued. For investors to buy stocks at fire-sale prices, not worry too much when they lose their job, deal with sudden medical expenses, or send their children to school, they must be prepared to sacrifice a fair chunk of their fixed-income assets at some point in their lives. “As such, I suggest you mentally vaporize all of your stocks and maybe half your bonds.”

By expecting a portion of their stock or bond portfolio to burn or be burned, Bernstein said, investors will find it easier to play the long game. That involves accumulating stocks while one is relatively young, exchanging some of them for bonds in good times as one moves toward retirement, finance their early retirement with savings or some continuing work in order to put off collecting their public pension benefits, and have at least 10 years’ worth of safe bonds to meet their living expenses in their sunset years.

“And if you still want to buy stocks at the fire sale, and especially if you want to endow the conveyors of your DNA into posterity, 20 or more years of bonds is even better,” Bernstein said.

While many might argue that a 60/40 portfolio can survive even the worst market, he pointed out that many investors will find it hard to accept when markets turn sour and they’re forced to sell devalued stocks to pay for living expenses or replenish evaporating bond holdings. “[I]t’s motionally tolerable only if your burn rate is somewhere south of 3% annually,” he said. “So, my advice is to mentally vaporize 75% of your portfolio, and when the crunch inevitably transpires, you will be psychologically well-prepared.”

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