Have You Considered These Six Ways to Conquer the Fear of a Plunging Market?

By Tom Madell

It appears that this may be a good time to discuss the possibility that stocks, and maybe even bonds, may have seen their best returns for a while. Even if they haven't, the 10 year bull market for stocks has been extraordinary and we all should know that bull markets don't last forever. So this might be as good a time as any to do some advance planning as to what one might want to do if stocks continue to underperform, or even enter a bear market in the future.

Why do most fund investors typically fear a market downturn? A stupid question you might think. A downturn suggests the possibility of even greater drops. Emotions can run rampant, as investors contemplate possible losses, or at least a diminution of prior gains. Fear is an extremely strong determinant of behavior, and when it comes to money, it may be the case that significant losses may have serious life-changing consequences for one's future hopes and plans. But short of that, our egos or even sense of competence in ourselves may suffer; after all, we were investing in order to gain money, not lose it.

Perhaps this is why, according to weekly fund flow data, investors are pulling money out of stock funds and ETFs almost every week since the end of 2018.

While it is natural to have such fears, should investors allow them to govern their behavior? While it may seem perfectly reasonable to abandon what appears to be a sinking ship, such an analogy is seriously flawed. A sinking ship, if it is truly sinking, cannot reverse the process. It will continue to take on water, until it is completely submerged. Sinking fund investments, however, in virtually all cases, will stop sinking, although they may have to go down further before this happens. But fear of losses seems to be experienced as an immediate threat, powerful enough that any thoughts that might restrain our action are no longer able to be given primary consideration. In the face of possible further danger, we act to protect ourselves, typically not allowing alternate possibilities to check our rampant emotion to flee.

All this is exacerbated by the fact that it is nearly impossible to correctly predict when a falling investment will reach its bottom. (Even the highest paid market experts can only offer guesses.)

There are ways, however, to counter the fear process which in reality is usually damaging to an investor's returns. But given the impelling nature of fear, this will require a well-thought out effort to reduce fear's ability to seemingly "force" us into a usually not-in-your-best-interest flee response. But to do so, one must allow oneself to fully consider and make every effort to adhere to certain thoughts both before and after investing that most other investors may have failed to consider:

1. Preferably before investing in a fund, make sure your time horizon is at least 3 years, preferably more. This will typically allow enough time for prices to recover from any potential bear market. (If you have already invested, consider whether you are prepared to wait it out for 3 years from now; if you aren't, you may want to sell at the first sign of a potential bear market.)

2. Be prepared for the fact that most of the significant gains made from mutual funds/ETFs come over years, not within days, months, or even a year or two. (When you sell your investment too soon, you probably will have missed the potential your fund offers.)

3. Keep firmly in mind that you haven't lost any money when your fund's price drops; you generally only lose money if you sell when the price is lower than when you purchased it, locking in the otherwise mere "paper" loss.

4. Related to 3, think of a price drop not as a potential loss, but as creating a more attractive price tag so that other investors will be more likely to step in and gradually boost the price (or equally, as an opportunity for you to buy more, potentially setting up more profit when you eventually do sell the investment. Or, you may want to initiate a new position in an investment whose price has dropped significantly. See "Why Price Drops Can Lead to Huge Subsequent Returns" below.)

5. Prevent being devastated by a drop in prices by setting a reasonable goal for an investment while it has already been doing well and selling some or all of the investment to lock in that gain. (For example, if while you are invested, your fund shows an average annualized gain of 15% over the past 5 years, you have made over 100% on your investment. By selling with a big profit in good times, you will offset at least some potential paper losses if the investment drops later on. Note: You might at first think that if a performance table shows you have a 15% annualized return over 5 years, you have made 75% on your investment (5 x 15%). However, you have actually done far better due to compounding. In this example, your return is a tad over 100%!)

6. If you still decide to sell a given fund after a big overall market drop, you may not want to pull out of the market altogether. Rather, seek out any alternative fund that may be at least somewhat undervalued; thus, you may want to exchange out of a more overvalued fund into one that has a likely better chance of appreciating in the future. (For example, right now Value funds appear more undervalued as compared to Growth funds, and Energy funds are particularly undervalued.)

Why Price Drops Can Lead to Huge Subsequent Returns

While price drops, or even bear markets may strike fear into even the most seasoned investors, the other side of the coin is that they can present what will prove to be excellent opportunities for subsequent growth. Here are three actual examples. (Note that not all returns will turn out as successfully.)

During the 3rd quarter of 2011, the average US stock fund registered a 3-month loss of -16.7% and international stock funds were down -20.5%. Since nobody would have been able to determine when the downdraft would stop, it is likely that some investors would have taken this as a signal to lighten up their positions. However, for those who didn't or used the price drops as an opportunity to buy, over the next one, three, and 5 years, three of my most highly recommended funds showed excellent annualized returns:

VFINX = Vanguard 500 Index Investor; VWIGX = Vanguard International Growth; VIGRX = Vanguard Growth Index Investor

An Update on My Present Overall Allocations to Stocks, Bonds, and Cash

One of the reasons I chose to abandon these recommendations is because I was getting the sense that they were no longer proving to be particularly useful, especially with regard to particular funds and fund categories. And, since every one has different objectives and risk tolerances, this was hard to capture thru my Model Portfolios. Additionally, not everyone has access to the particular funds I recommended. But I sense that my overall allocations to stocks, bonds, and cash may have been somewhat successful in helping people to continue in stocks, and have at least some bonds, even when it might have seemed best to do otherwise.

Recently, however, I received an email imploring me to continue making at least my present overall allocations to stocks, bonds, and cash for investors who may have come to rely on them. So, the following show my current overall allocations to stocks, bonds, and cash for three broadly defined "types" of investors.

Recommended For Moderate Risk Investors

Recommended For Aggressive Risk Investors

Recommended For Conservative Risk Investors

A Brief Discussion of Current Market Conditions

As of today (May 30), it appears that the 3 major stock indices will have dropped for 6 consecutive weeks. Bond prices, on the other hand, over a similar period, have generally increased. Investors, apparently, are beginning to take more seriously the possibility of an extended trade war.

Most economists take the position that an unresolved trade war between the U.S. and China will hurt both sides, with many trading partners of each country getting hurt as well. Some even suggest that this may be the start of a new economic "cold war" between the two superpowers.

If the current still unpredictable status quo continues to play out, economic outputs will likely slow, hurting most stock prices. Bond prices, on the other hand, may continue to increase as slowing growth tends to scare investors away from stocks and into the relatively greater safety of bonds. The one major exception in the bond market would be high yield bonds which tend to follow the direction of the stock market rather than other bonds, but not as dramatically.

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