CHAPEL HILL, N.C. — There may actually have been a silver lining to the coronavirus-induced stock market plunge last week.
That’s because it may have taught us — in a way that no amount of armchair self-exploration could — how we are likely to actually react during a major bear market in stocks. And that is crucial information, for it helps us determine which investment approaches are most appropriate for the long term.
Gaining such insight is important any time, of course, but especially now, given that the last severe bear market ended nearly 11 years ago and memories of it have long faded. In fact, some millennial investors have no memory whatsoever of anything other than an almost uninterrupted bull market.
This in turn has encouraged a false bravado among many investors. They confidently assert they have the foresight to focus on the long term and the discipline not to let any decline tempt them into throwing in the towel on their equity investments.
Then comes last week’s plunge, which let us know whether we actually can walk the talk. In almost all cases, the answer is “no.”
Most wannabe contrarians in a bull market endlessly say they believe Baron Rothschild’s famous advice that “the time to buy is when the blood is running in the streets,” but then lose faith the moment when things start looking even mildly dicey. What did they think he meant by “blood running in the streets?”
To be sure, you might object that reacting to a novel virus is different than figuring out how to react when there is a purely financial crisis. The market’s decline in the fourth quarter of 2018 comes to mind, when the S&P 500 index SPX, +4.60% fell 20% in the wake of the Federal Reserve’s interest-rate hikes.
In fact, however, what’s plagued the markets over the last couple of weeks is child’s play compared to what Rothschild faced when he made his famous statement. He invested in the wake of Napoleon’s loss at the Battle of Waterloo. His full statement is reported to have been “Buy when there’s blood in the streets, even if the blood is your own.”
To be sure, there is no shame in realizing that you’re not a true contrarian in the Rothschild mold. The only shame, if there is any, is in lying to yourself that you really are a contrarian when in fact you’re anything but.
And that’s why last week was so valuable. Even if you didn’t sell into the plunge, were you scared? Be honest. Are you really and truly the genuine contrarian who welcomes a severe decline as the opportunity to pick up good quality stocks at bargain prices?
Being above average in both up and down markets
If not — and very few investors can truly say yes — then you should reduce your portfolio risk to whatever level you can tolerate through a severe bear market. Chances are that the strategy you choose will not be 100% allocated to equities.
That’s not because a broad market index fund, held for the long term, isn’t a statistically superior strategy. If choosing the appropriate strategy were a matter solely of statistics, the decision would be easy: Buy and hold equities over the long term, period.
But we’re emotional beings who respond to factors other than just objective statistics. And it does you little good to pursue a statistically superior strategy if you throw in the towel at the bottom of a bear market. In that event, you will lose big. You will make more money over time pursuing a statistically inferior strategy that you nevertheless are able to actually pursue through a bear market.
One approach that is both statistically and emotionally realistic, which I often recommend to my clients, is to find advisers who have produced above-average returns in both up and down markets. That might not seem that impressive an achievement, but it is; most advisers, even those with excellent long-term records, may perform spectacularly when the market is going their way but then lose big when it doesn’t. Their approaches are perfectly OK for those with nerves of steel.
For those without such nerves, however, slow and steady is an approach more likely to help them achieve their long-term financial goals. The investment newsletter honor roll I construct contains those few services that have produced above-average performance in both up and down markets.
It can seem odd that I am even suggesting that you consider following a service that is not at the top of the performance scoreboards. After all, I have dedicated my career to objectively calculating advisers’ track records. But I have learned that I don’t do my clients any service by recommending they follow a service with a great track record, if they are unable or unwilling to actually follow that service through a bear market.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org.