Bear Market Portfolio Protection Part 3

Third in a series of posts about protecting your investment portfolio from a bear market.

Part One explained what type of market decline you should be worried about and what protecting yourself really means.

Part Two dealt with structuring your portfolio to avoid having to sell stocks when they’re down to meet your spending needs.

Part three covers avoiding panic during steep market sell-offs, so you don’t bail from your investments at the wrong time.

Stocks can provide a hassle-free return. Unlike managing real estate or running a business, which typically require time, operational skill, and effort, stocks are easily invested in – open an account, deposit cash, buy a diversified mutual fund or ETF and get hassle-free returns.

Hassle-free doesn’t mean easy.

Investors have had a remarkably difficult time sticking to their long-term investment strategy.

Market volatility rattles investors’ nerves and exposes them to their biggest enemies – fear and greed. Fear during bear markets makes you jump out of the market when things are tough and turns short-term losses into permanent ones.

Investors have repeatedly done this. We can measure it in many ways. One of my favorite is the DALBAR, Inc. study that shows how investors have historically performed.

Because of poor investment timing decisions, like getting aggressive and buying stocks at the wrong time because everyone they know is making a killing in tech stocks (late 90’s), or selling stocks when everyone is afraid the world will end (2008), investors have struggled to earn decent returns.

To protect yourself during a bear market, be aware that your natural instinct to just do something when your portfolio is down is counter-productive.

It locks in losses. It keeps you out of the market during the inevitable recovery. It’s the opposite of what you should be doing since stocks are now on sale.

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

– Warren Buffett

Yet, sticking to your long-term strategy, much less buying more when stocks are cheaper, is extremely hard to do. Twenty years as a financial advisor have taught me this. During two bear markets and numerous corrections, I have rationalized, begged, pleaded, instructed, and advised folks to hold on and wait for the recovery. It’s one of the most valuable services an advisor provides – keeping you from abandoning your investments at the wrong time.

For those of you without an advisor, or who need an additional reminder, I’d like you to consider this analogy I originally posted here when thinking about how to respond to a market decline.

Have you ever sold your house? It’s usually an emotional process involving many important steps: 

1. Finding a realtor to guide you through a major transaction
2. Following their advice on repairs and updates to make the home salable
3. Deciding on a listing price after reviewing recent comparable transactions and market availability
4. Figuring out when to list
5. Creating the right marketing plan, including a write-up, photos, number of open houses, etc.

Then, the first offer arrives. You had a realistic asking price of $400,000, would have taken a bit less to get a deal done, but your realtor breaks the bad news that someone just offered $350,000 – 12.5% less than what your home is worth.

You’re ticked off. You tell the realtor that the lowball offer won’t work. Not only that, you won’t counter because the purchaser isn’t serious. You’re going to be patient and wait for the right offer from a realistic buyer.

I’m not a real estate professional, but I have been involved in enough real estate transactions (and seen clients go through many more) to know that the above scenario happens all the time.

Unless they’re in a jam, people don’t accept lowball offers on their house. They either ignore them, or find them offensive and dumb.

So, why do people seem to have the exact opposite reaction when the market starts making lowball offers on their portfolio?

You meet with a financial advisor, or do the following work yourself. You organize your financial data, figure out goals, fears, and future plans. You build a strategy to accomplish important future objectives. You set aside enough short-term money in a rainy day fund for emergencies. You decide on an investment mix to grow your portfolio, including what investment philosophy to employ, what mix of stocks, bonds, and other investments to include based on your plan, and which specific investments to use. 

You know you won’t touch your portfolio for years, perhaps decades, but then the market starts making you crazy offers for it. Unsolicited offers. At least with real estate, your home was for sale when the lowball offer arrived. Your portfolio is not for sale, yet the market is quoting you a price on it every second it’s open.

To be fair, the price bounces around a lot, and it’s hard to understand why. Reviewing real estate comps and having confidence in what your home is worth is much easier than trying to understand what a portfolio of hundreds, if not thousands, of underlying investments is worth. 

Sometimes you react to the price offers with amusement, perhaps telling your spouse or best friend how much you’re making. Sometimes you react to them with disappointment, hoping the prices will recover, but understanding that it’s a long-term game.

But when those real lowball offers come in, do you react the same way you would when someone wanted to buy your house for $50,000 less than asking price?

Nope.

For some reason, we’re much more willing to take seriously a market’s lowball offer on our portfolio than on our house. 

We don’t get ticked off that the market is trying to scoop up our hard earned savings cheaply.
We don’t turn CNBC off because it’s not quoting serious prices.
We aren’t patient, we’re stressed.
We don’t get offended, we get upset.
We lose sight of the fact that we have built a thoughtful plan and portfolio strategy and start to give the lowballs much greater power over our financial wellbeing than they deserve.

It’s important to remember that the number of buyers and sellers in the market always matches up (contrary to the silly notion that the market goes down because there are more sellers than buyers). 

So, when the market lowballs you, imagine that real estate buyer sliding an offer sheet across your kitchen table trying to buy your brokerage account and 401(k) for less than what they were recently worth – at a time they are not for sale! In my imagination, not only do you stick to your plan and say no, but you try and scrape together some cash and see if you can find someone willing to part with their hard earned investments in this fire sale.