Preparing For The Grizzly Bear

The next bear market may not be a teddy bear. Overcome these three biases before it’s too late.

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Reviewed by: Allan Roth
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Edited by: Allan Roth

All I need is a 15% annual return on my portfolio,” one person recently told me. Indeed, that’s less than the 16.33% annual 10-year return of the Vanguard Total Stock Market ETF (VTI) as of Nov. 3, 2021. In fact, over the past five years, it notched a 19.48% annual return. And this person was more than 100% in stocks, using levered ETFs.

Indeed, it looks as if nothing can stop this market where VTI is up 120.1% since the COVID bottom on March 23, 2021. Over the last three years, we have had a pandemic, massive unemployment and deficit spending, social unrest and a dysfunctional political system, yet VTI responded with an 80.38% return, or 21.73% a year.

 

Vanguard Total Stock Market

VTSMX as a surrogate for VTI, which didn't exist for the entire period.

(For a larger view, click on the image above)

 

But don’t get used to these returns! Intellectually, we know a bear is coming, but I don’t think people understand it emotionally. And people have gotten used to what Jason Zweig of the Wall Street Journal called “Teddy Bears.” These bears recovered very quickly.

Let’s look at the three teddy bears of this century and examine what would happen if a grizzly bear shows up. In the following chart, you can see that the teddy bears looked fierce at first but didn’t last. The recovery for each was fast, especially the COVID bear.

 

3 Bear Markets This Century

Source: Calculated from Wilshire Associates data

(For a larger view, click on the image above)

 

What worked in each of the three recent bears wasn’t the same. During the dot-com bear, REITs, precious metals equities and small value saved the day. But they each failed miserably during the next two bears. Only high quality bonds worked for all three bears.

 

Asset Class Dot ComRE/FinCOVID
Total USWilshire 5000 -48.6%-55.2%-34.8%
Small ValueWilshire Index-2.8%-59.7%-43.3%
Lg GrowthWilshire Index-64.0%-51.1%-33.5%
REITWilshire index34.1%-71.3%-41.7%
Vang Tot Bond VBMFX 27.0%7.3%-1.1%
Vang Hi Yield VWEHX -2.2%-23.5%-19.7%
PME Invesco Opp OPGSX 34.0%-43.0%-32.3%
Vang Total Int'l VGTSX -49.0%-60.3%-33.3%

 

The Grizzly In Consequences

Intellectually, we understand recency bias, and most of us know a bear can be fiercer and hang around much longer. Zweig noted U.S. bears have lasted nearly 20 years. And just recently, the Japanese stock market recovered from its 1989 high—that’s 30 years! If you think that can’t happen here, I suggest you rethink your position—and I’d do it sooner rather than later.

Rather than throwing out numbers and probabilities, I urge people to think in terms of consequences. Would you take a bet where you had a 90% chance of winning $1 billion but a 10% chance of dying? I hope I wouldn’t, because the consequences are too high.

To a lesser degree, the same goes for investing. Sure, we will feel better if stocks continue to surge and we are very heavily in stocks. But Daniel Kahneman’s prospect theory shows we will feel far worse if stocks plunge. Why?  In part, due to consequences.  

Try to imagine what would happen if stocks lost 70% and stayed down for years. It might mean things like:

  • You cannot afford to send your kids and grandkids to college. In fact, you need to take back those college 529 accounts you set up for them.
  • You must sell that vacation house even though the market is quite depressed.
  • You must either sell your home or take out a reverse mortgage to have cash to live on.
  • You must figure out how to cut your monthly expenditures in half even though you say only 20% is discretionary. Maybe one of the kids will let you live with them?

Embrace the pain you would feel. Even if you didn’t need to cut things out, I’m pretty certain that you’d feel a lot of regret if you were heavily in stocks and lost more than half of your net worth.

To make changes, you’ll have to overcome these three biases:

  1. Recency bias. Stocks have been on a tear for most of the last dozen years, and bonds have declined a bit.  It’s human nature to want more of what’s done well.
  2. Bond bias. There is a belief that bonds aren’t yielding much and that interest rates have to go up. The first part is partially true but not totally. Back in 1981, you could get 12% on a bond which, after taxes, yielded only about 8%. Inflation was as high as 14% then, so one lost as much as 6% of their spending power. The after-tax real yield is better today. And the top economists have a terrible track record of predicting the 10-year Treasury bond rate.  The belief that rates will go up when the government stops quantitative easing was dead wrong after QE ended when the financial crisis ended.
  3. Tax bias. We don’t like to pay taxes. Because stocks have appreciated, it’s likely we may have to pay some taxes to rebalance. But when the grizzly comes around, your tax problem may be solved, but this isn’t a good thing. Assuming you will eventually sell the stock ETFs to live on (versus passing it on with the step-up basis), this is merely a timing issue. There is, of course, a risk that tax rates go up.

Conclusion

I’ve never done a financial plan where I’ve had the client buried with their money. So the primary purpose of your portfolio is to achieve financial independence to do what you want for the rest of your life. The closer you are to reaching that financial independence, the less risk you should take.

So my advice is to protect your financial independence from a bear market that doesn’t resemble the last three. If the grizzly doesn’t attack, it will have been the wrong decision. But if it does, you’ll be protecting your lifestyle and have some dry powder in your bond ETFs to then rebalance and buy the stock ETFs when they are on sale.

Remember the words of Warren Buffett: “Be fearful when others are greedy.” Greed seems to be winning the day, which makes me fearful. I’m afraid of grizzly bears—they are fierce!

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for Barrons, AARP, Advisor Perspectives and Financial Planning magazine. You can reach him at [email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.

Allan Roth is founder of Wealth Logic, an hourly based financial planning and investment advisory firm. He also benchmarks portfolio performance for foundations and other business concerns. Roth's website is www.DareToBeDull.com. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter

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