NOTE: There is a 100% probability that bull markets will be followed by bear markets. This article is not a forecast about imminent market behavior. For our latest views on markets, clients should read our market review. Financial fire drills are all about testing your emotional response to a bear market, which you should be doing all the time. (And it’s not a bad idea to check your emotional reaction to bull markets, as well.)
When I was a kid, my family lived in a two-story colonial in South Jersey. Once each year, to the great excitement of all concerned, my parents had my brother, sister, and me conduct a fire drill. We got to climb out of our bedroom window onto the roof of the garage, and then down from there.
Our house never suffered a serious fire, and we never had to make a rooftop escape, but my parents were still glad that we’d practiced what we had to do, just in case. It was a very good idea.
Now that we are five years into this particular bull market, it’s time to hold an equivalent fire drill for your portfolio. How will you respond to a bear market? If the answer, after your drills, is that you’d do nothing, then you’ve spent your time wisely. If on the other hand your answer is to “Sell,” it’s best to have a discussion with your advisor right now… before we get into the pure terror of a bear market.
After a record run (either measured from the market’s low in March 2009, or from the low in 2011) the stock market is expensive. While valuation has always been a lousy market-timing indicator, if history is any guide, the risks of a serious market slide are growing. And after such a long rally, investors would be wise to plan for a significant market decline.
How To Run Your Portfolio Fire Drill
The best way to conduct a bear market fire drill is to fully understand the implied volatility of your portfolio policy (or put another way, the implied volatility of your current asset allocation). If your policy is ‘moderate’ you probably have an equity allocation of something like 50% to 70% of your portfolio; ‘growth’ policies are typically 70% or more of risk assets; and ‘conservative’ allocations are typically 50% or less of equity exposure. Unless you’re a tactical investor who employs market timing techniques to sell risk in advance of (or during) a market decline, then you should consider what kind of downside risk you’ve built into your portfolio.
As you might guess, the more fixed income in your asset allocation, the less impact a stock sell-off will have on your portfolio return. Remember that we are talking about portfolio return, since you should expect that in a bear market your stocks will sell off in amounts similar to the market. More sophisticated investors can make an adjustment to their estimates if they own defensive equities that would reasonably outperform in a serious market decline. But given that your risk assets give you market returns in a bear market, you can make some reasonable assumptions about what a market collapse would mean for your portfolio.
Here are estimated max drawdowns for some basic portfolio policies: (Note: “Max drawdown” is the decline in your portfolio value — from the highest value to the lowest value — in a bear market.)
|Portfolio Policy||Max Drawdown|
|Conservative (40% equity and 60% fixed income)||-15%|
|Moderate (60% equity and 40% fixed income)||-25%|
|Growth (80% equity and 20% fixed income)||-35%|
|Aggressive Growth (100% equity)||-45%|
These drawdowns are not predictions of actual portfolio performance, but are nevertheless quite useful for previewing how you’ll feel if we get a bear market of -45%.
The Moment of Truth…
In order to make the best use of this information, first convert the percentages into dollar amounts based on the size of your portfolio. If you own liquid assets of $500,000 and your portfolio policy is moderate, then the drawdown you should be contemplating is $125,000. Now think about how hard you worked to accumulate $125,000 after taxes. Hours of sweat equity that the financial markets are wiping away in what seems like a heartbeat. Imagine the headlines that are sure to accompany such a market rout… the hosts of your favorite financial TV shows glumly covering the day’s losses, with experts pontificating on how things are sure to get worse. And as this is occurring, your friends will probably be telling you how they got out of the market months ago and are safely in cash while you stare at the abyss.
So how do you feel? You now have a $375,000 portfolio and your financial advisor is telling you the market is cheap and it’s time to buy. Are you a seller instead? Are you losing sleep? Do you find that while you know intellectually that it’s a good time to buy, your emotional state is telling you to cut and run?
It’s important to be honest with yourself. If you believe you cannot live with the kind of loss your portfolio would suffer in a bear market, then you should call your financial advisor immediately and discuss the situation. You’ll probably need to reposition your portfolio to something you feel more comfortable with, and this is not something you want to do in the middle of a frightening bear market. After the gains of the past five years, it is nothing but good planning to restructure your risk positions and take some gains off the table. Rebalancing in a bull market makes sense, while selling into a bear market can be a disaster.
At the end of the day, your risk tolerance is unique to you; when it all hits the fan, the only emotion that really matters is yours. That’s why it’s important to train yourself through practice to expect a big decline in a bear market, and to be prepared to accept the consequences of it. The result could be a huge gain in your wealth, because you didn’t sell at the bottom.
Not too bad for a fire drill.
Copyright: jamroenjaiman / 123RF Stock Photo