With the S&P 500 more than 20% off its peak, and tech stocks down even further, your first task is to take a deep breath and assess your risk.
Individual investors need a new playbook—or maybe a revised version of the old one. The rally in stocks that had been boosting retirement fund balances sputtered early this year, but it came to a sharp end on June 13. That’s when the S&P 500 finally slipped into a bear market, which is generally defined as a market close at least 20% below its peak.
But honestly, it probably feels a lot worse than that for many investors—and it has for a while. The handful of megacap tech stocks that served as jet fuel for the overall market have fallen much harder since the S&P’s Jan. 3 peak, with Meta Platforms down more than 50%, Amazon.com falling 39%, and Microsoft, Apple, and Alphabet all losing about a quarter of their value. The growth-stock driven Nasdaq Composite Index has been in a bear market since March and is down 32% from its high last year.
If you widen the lens to include cryptocurrency … well, there’s a lot of pain out there. All these declines and dislocations can make us more emotional investors, whether we realize it or not.
One way emotions affect investing behavior is that we feel losses more intensely than we perceive gains. To see an S&P 500 index fund fall 20% can quickly overshadow the fact that the index has still returned, with dividends, almost 70% over the past five years. If you’ve been steadily investing in a diversified portfolio for years, you don’t need to be beating yourself up over any big mistakes right now. Your best response to a bear market may be to stick with your plan. If you are continuing to invest a bit of your paycheck each month, you are at least buying stocks more cheaply now.
That said, the unease you may be feeling can serve a purpose if it leads you to take a hard look at the makeup of your portfolio and the level of risk it carries. It’s a good time to ask if you really are comfortable with that risk and if it’s likely to serve you well across many market cycles, not just during bull runs.
Start by asking yourself if you became too dependent on just one sector or a group of hot stocks. The past several years were remarkable for how much investors had riding on tech stocks. Even after the big plunge, the top five technology-driven stocks on the S&P 500 still make up more than 20% of the market capitalization-weighted index.
Many investors—especially those who pick individual stocks—made even bigger bets. They became understandably devoted to popular stocks such as Tesla Inc. that had delivered large gains for them, a phenomenon known as anchoring in the world of behavioral finance. “You basically think the company will only go up, and you lock yourself into the position and put blinders on,” says Dave Alison, of Alison Wealth Management. “People make a big mistake by not taking gains along the way, and when a stock crashes 30% or 50% they kick themselves.”
When Alison finds a client in this position, he may ask them to set a maximum amount of their portfolio, in dollars, they want associated with the stock. The client agrees that every time the value rises above that, he can sell and diversify into something else. In theory, as growth stocks rose and rose and rose, investors could have systematically taken gains and moved that money into value-style stocks, which were longtime laggards in the bull market. “You’d still participate in the growth style, but you reduce your risk while building more ballast in value, and now you have smoother volatility and not so much excess in any direction,” says Alison.
If you still have a lot in tech stocks, you may not want to aggressively sell now that they are cheaper, but consider making them less dominant in your portfolio. Looking ahead, you can apply the same thinking to the sectors that are doing well now. Driven by the supply shock created by the end of pandemic lockdowns and Russia’s war on Ukraine, energy stocks on the S&P 500 have returned more than 50% this year. Although there’s a case that onetime deep-value stocks like these still have a way to run, growing exposure to any winning stock bears watching.
One way to manage the long-term uncertainty in markets and lessen volatility is to give up on making all-or-nothing decisions. Say you are agonizing about selling a stock. “If you’re ever in doubt, or if your brain is saying, ‘What if I just keep holding this stock for a few more days?,’ if you want to be a genius, sell half of your position,” says David Wright, co-founder of Sierra Investment Management. “You’re a genius if the market recovers, because you haven’t sold it all, and if it continues down, you’re a genius because you protected half of your holding from going down that far.”
Next, it’s more important than ever to ensure you are diversified. A mix of stocks and bonds still provides important ballast for your portfolio. But let’s not sugar-coat the current situation: Bonds are losing money in this equity bear market, too. Rising inflation and interest rates have been bad for the prices of bonds, sending the Bloomberg US Aggregate bond index down more than 10% so far in 2022, about half as much as stocks.
For investors holding investment-grade bonds directly, rather than in a fund, the pain of this may be eased by not having to look at the current losses. “While your bond portion of your portfolio is down, you have a contractual agreement with the issuer and will receive the full face value of your bond upon maturity,” says financial planner Laura Mattia of Atlas Fiduciary Financial. “So your bonds are not really down.” Barring a default, you’ll collect the interest you expected and get the principal back at maturity.
Investors in bond funds see their current losses more clearly, because the falling market prices of bonds are reflected in a fund’s return. The good news is that while the prices of bonds in portfolios are dropping, the yields they are paying are finally rising from rock-bottom levels. That strengthens the argument for bonds as diversifiers now.
One type of fixed-income investment that offers a particularly strong hedge against inflation is a Series I savings bond from the US Treasury. Although the bonds have to be held for at least a year, and you lose three months’ worth of interest if you cash them in before five years, the current yield on the bonds, which can be bought at treasurydirect.gov, is 9.6%—a deal that’s pretty hard to match these days. The rate moves along with the inflation rate and is reset every six months. One catch: There’s a limit on how much you can buy each year.
Other assets that can add diversification over time include real estate investment trusts as well as international stock and bonds. But, again, none of these have been shelters from losses in this roiling year. The point is that by investing broadly you improve your chances of capturing some bargains now and smoothing out returns in the future. “The early stages of a bear market tend to be a ‘take no prisoners’ environment and everything is hit, including diversifiers,” says Rob Arnott, founder of the asset management firm Research Affiliates. Eventually, though, “the market starts a sorting process that can be massively beneficial to diversifiers.”
One asset class that was heralded as a possible hedge against falling markets and inflation was cryptocurrencies. The reality has proven to be quite different, with tokens trading far more like risk assets than safe havens. Bitcoin has slumped 65% from its November high, while Ethereum has tumbled 73%. A lesson worth taking home from this crash is that whatever your views on crypto, you need to think of it much more as a speculative bet than as a diversifier.
What about retreating into cash? That’s a bad idea as a timing move—it’s simply too hard for most people, including professionals, to correctly guess when markets will turn. But this bear market is a reminder that for many people in retirement or nearing it, having a good slug of cash is smart. No longer having a steady paycheck means that recovering from any losses will be much harder than it would be for a younger investor, and needing to sell into a depressed market could permanently damage a nest egg.
For clients who are still working, wealth manager Alison recommends three to six months of liquidity in cash, but he bumps that to a year’s worth of income if someone is retired. “Cash” doesn’t mean only money in the bank. It could include liquidity available through a home equity line of credit for an emergency, or the ability to borrow against the cash value built up in permanent life insurance. Sometimes Alison will open a securities line of credit on a client’s brokerage account.
A simpler solution is high-yield savings accounts, where yields are starting to inch up. Money market funds are another solution, with interest rates that climb quickly as benchmark rates rise. —With Claire Ballentine
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