Swedroe: Are You Prepared To Face A Bear?

October 17, 2014

Don’t panic. Ask yourself a few questions instead.

It seems investors have had plenty to worry about recently, even without considering the last few weeks of stock market volatility. After all, we’ve seen:

  • Slowing growth in most of the developed world, including the possibility that European economies will enter their third recession since 2007
  • Growth in China’s economy decelerating faster than expected
  • ISIS on the march
  • The end of the Federal Reserve’s bond buying program, and the accompanying threat of rising interest rates
  • A rising dollar’s negative impact on the competitiveness of U.S. manufacturers
  • “Sky high” valuations as the Shiller CAPE ratio rose to above 26 (versus the historical average of 16) and still remains at about 24.
  • Nervous investors anxious about the threat posed to the global economy by the Ebola virus

Now add to this list the sharp and sudden drop that equity markets have experienced since the S&P 500 peaked on Sept. 18. If all the negative headlines have caused your stomach to produce a lot more acid, resulting in some sleepless nights, you should answer certain questions before the stress causes you to embark on a bout of panicked selling.

What Would Warren Do?

First, ask yourself about the reasons for your concern. Then ask if you’re the only one who knows those risks exist. Obviously, the answer is no. Thus, you should acknowledge that bad news doesn’t necessarily mean markets will go lower.

As I discuss in my book, “Think, Act and Invest Like Warren Buffett,” one of the secrets to Buffett’s success as an investor is that during bear markets, he’s able to keep his head while everyone else around him is losing theirs. He understands that the market price already reflects all information that is knowable.

In other words, prices and valuations have fallen because the news has been bad. Those lower valuations mean that expected returns are now higher, reflecting the heightened risks. If you bought previously, when expected returns were lower, does it really make sense to sell now, when they are higher?

This brings to mind something Buffet said in an op-ed for the New York Times, back in the bear market of 2008. He wrote: “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”

The fact that bad news is already embedded in prices means that markets can be expected to continue to fall only if future news is worse than already expected. If the news is no worse than expected, you will likely earn higher returns resulting from the lower valuations.



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