Swedroe: How To Think About Bear Markets

Until quite recently, 2014 had been a very quiet and calm year for the stock market. With the exception of a few days in early February, the VIX had never spent any time above 20. As August ended, it stood at just under 12.

However, volatility has a nasty tendency to spike. And as AQR’s Cliff Asness explained, it can also be sticky: “When the market is volatile your best guess for next month is that it will be more volatile.” During September, the VIX began to creep up, ending the month at 16.3. Then, on Oct. 15, it spiked to above 31.

One thing I’ve learned over the years is that there’s a perfect correlation between a rising VIX and the volume of forecasts in the financial media predicting doom, as well as the number of calls and emails I receive from nervous investors and advisors.

Preparing For Volatility

With this in mind, I thought it worthwhile to discuss what you should do the next time there is an alarming spike in volatility.

The most important thing to understand is that both bear markets and volatility are inevitable. In fact, they are the true source of the equity risk premium, and why it has historically been so large.

Think of it this way: Stocks are riskier than bonds. Thus, investors demand a premium, in the form of a higher expected return, as compensation for taking the greater risk stocks entail. The key word is “expected.” If stocks always outperformed, there would be no risk in purchasing them. It’s the risk of the unexpected happening that leads to the equity risk premium.

The Importance Of Bear Markets

There’s another key point that warrants explanation. We’ve had three severe bear markets over the past 45 years: 1973-1974, 2000-2002 and most recently the one that began in late 2007. Remember, the equity risk premium is the compensation investors receive for bearing the risk of severe losses.

Now, imagine that instead of three bear markets that each saw market losses of about 50 percent or more, that the worst bear market over the past half-century had a loss of just 25 percent. If that were the case, investors might not consider stocks so risky. They wouldn’t require as large a risk premium because they’d be willing to pay higher prices, which is to say that valuations would be higher.

Thus, while it doesn’t feel like it at the time, severe bear markets are really a good thing—assuming you have the discipline to stay the course and not engage in panicked selling. If we didn’t have bear markets from time to time, valuations would be persistently higher. As a result, stock returns would have been persistently lower than they’ve actually been.

Discipline: The Key To Success

There are two keys to having discipline. The first is to accept the inevitability of bear markets as well as their unpredictability. In fact, about the only things we don’t know about bear markets are some of the most important—what will cause them; when they will occur; how deep they will be; and how long they will last. Since battles are won in their preparatory stages and not on the battlefield, to have financial discipline, you must accept these facts and build the inevitability of bear markets into your plan.

That means you cannot assume more risk than you have the ability, willingness or need to take. Otherwise, when a bear market does arrive, it’s likely your stomach will take over the decision-making. And I’ve yet to meet a stomach that makes good decisions.

The second key ingredient to success in staying disciplined is to understand that, since diversification is the only free lunch in investing, you should eat as much of it as possible. So how should investors think about diversification?

Thinking About Diversification

When investors think about the diversification of their portfolios, they often think in terms of correlations—the lower the correlation, the more effective a diversifier will be. While this is true, you shouldn’t consider only the long-term correlations. Correlations aren’t constant. As a result, it’s important to also consider times when correlations tend to rise and when they tend to fall.

During periods of stress in financial markets, the correlations of all risky assets tend to rise. Risky assets—such as high-yield bonds, preferred stocks, convertible bonds, emerging market bonds, real estate and MLPs—do have a low average correlation to stock. But during bear markets, their correlations have a nasty tendency to rise toward 1—and at exactly the wrong time.

While diversifying across equity asset classes—such as small and value, real estate, international developed markets and emerging markets—is a good strategy, it won’t help during bear markets. In fact, it may very well exacerbate portfolio losses.

On the other hand, high-quality bonds, such as Treasurys, which have basically no correlation to stocks over the long term, tend to see their correlations turn sharply negative—and at just the right time. Thus, the most important diversification tool for an equity portfolio is to make sure it includes sufficient high-quality bonds to dampen the risk of the overall portfolio to an acceptable level.

Diversification Across Sources of Returns (Not Just Asset Classes)

There’s another helpful way to think about diversification. Instead of considering only diversification across equity asset classes, think about it in terms of exposure across the factors, or sources of returns. But only in situations where there’s strong evidence that a factor has both persistently—across time and economic regimes; and pervasively—across geographic regions and even asset classes, have delivered premium returns.

This can be accomplished by “tilting” a portfolio more toward small and value stocks than the makeup of the overall market. The overall market, while owning small and value stocks, by definition has no exposure to the small or value factors. Neither does it have exposure to momentum, nor quality. These factors have all been shown to provide premiums.

And those premiums can be used in one of two ways. The first is to provide higher expected returns. This diversifies the portfolio away from a single factor, beta. The second is to use the premiums—and their higher expected returns, to allow you to lower your allocation to beta.

This permits you to move toward more of a “risk parity” strategy. This strategy calls for lowering your exposure to beta while raising your exposure to safe bonds as well as the other factors, each of which has low correlation to beta.

My book, co-authored with Kevin Grogan, “Reducing the Risk of Black Swans,” demonstrates how a low-beta/high-tilt portfolio, which uses only safe bonds, has delivered superior risk-adjusted returns by cutting tail risk and reducing volatility.

Market-Neutral Porfolios

Investors can also diversify their sources of return by reducing their equity exposure and investing that allocation in a market-neutral/long-short strategy, such as the one provided by AQR’s Style Premium Alternative Fund (QSPIX).

The fund provides investors with exposure to four styles, or factors:

• Value (the tendency for relatively cheap assets to outperform relatively expensive ones)
• Momentum (the tendency for an asset’s recent relative performance to continue in the near future)
• Carry (the tendency for higher-yielding assets to provide higher returns than lower-yielding assets)
• Defensive (the tendency for lower-risk and higher-quality assets to generate higher risk-adjusted returns)

The fund invests across asset classes; specifically, stocks, bonds, commodities and currencies. The long/short nature of the fund means it has no exposure to beta, while providing exposure to four factors that have delivered premiums and simultaneous exhibiting very low to negative correlation to each other.

For example, from 1990-2013, the value premium exhibited negative monthly correlation to the momentum, carry and defensive premiums. The carry premium showed negative correlation with the value premium, basically no correlation with the defensive premium, and a low correlation with the momentum premium. And momentum had a negative correlation with the value premium, and showed low correlation with the carry and defensive premiums.

By thinking differently about diversification, and eating as much of that free lunch as possible, you can reduce the expected volatility of your portfolio, reduce downside risk and improve your portfolio’s efficiency.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.