Last updated: October 07 2008

Are You Ready for a Bear Market?

David Christianson, BA, CFP, R.F.P., TEP

I always like to ask that question when the markets are high, as that is the ideal time to assess your preparedness for a bad market. I ask the same question in sideways markets and bad markets. That's why I asked the question in 1994, 1998, 2000, 2005 and again last year.

Why this theme? Because investors must always be ready for a bear market. Bears follow bulls as surely as winter follows summer. (Good news is that, unlike Winnipeg winters, bear markets are shorter than their opposite season.)

In our professional practice, we are always looking at our client portfolios and asking, "Is this financial plan ready to withstand a bear market? If stock prices collapsed tomorrow, do we have enough cash, short-term and guaranteed investments set aside to provide all the client's spending requirements until the markets recover?"

It takes a lot of discipline to consistently ask this question when the markets are at record highs and clients are resisting investments into boring old bonds that will only pay them 4%. However, it's those preparations that carry us through tough times like 2008.

It's a lot tougher to ask the question after the markets have declined 20%, but you still have to ask it and make the necessary adjustments and provisions.

Bear market facts. The accepted definition of a bear market is a stock index declining 20% from its previous peak. We are now officially in a bear market.

Since 1970, there have been six bear markets on the Toronto Stock Exchange. The declines ranged from 20% to a high of 43%, for the longest bear, from 2000 to 2002. (Remember that much of that decline was due to the decline of Nortel, which made up over 20% of the total market at its peak.)

In all cases except 2002, the stock market started its recovery before the economy emerged from recession. The 2002 stock market recovery was delayed by historic events like 9-11, and the crush to confidence from accounting fraud in companies like Enron, WorldCom and others.

What about recoveries? The average return has been 25% for the 12-month period after the end of the last four bear markets. The lowest 12-month return was 15.2%, and that was produced even while the 1991 recession was still working its way through the economy.

A bear market is different than a quick correction, in that it can last quite a while. A rapid correction is easier in many ways, because the pain is over quickly. In a real bear market, the market can decline for months or even years, with short rallies in between to keep our hopes up.

The possibility (or the reality) of a bear market is not a reason to pull out of the markets or to stop investing. Like a bull market, a bear market can stop at any time and turn around. It usually happens when things look very bad for the economy. The important thing is to make sure you are ready, in case this bear market is not over.

Are you ready financially? Will you be able to leave your investment portfolio for the two or three years that could be required? Better yet, will you able to add more money and buy stocks at real bargain levels? If you will need cash from your portfolio in the next year or two, make sure that you've put that money aside in money market funds or other guaranteed vehicles.

Are you ready psychologically? Do you have what it takes to ignore all the pundits coming out of the woodwork, saying they told us so? Market gurus tend to want to make headlines by over-dramatizing a situation. The media tend to exaggerate these dramatic comments because they make great headlines.

When these stories start to suggest that all of our assumptions about a rising market in the future were wrong and the market will never rise again, are you prepared to ignore the noise and continue to invest according to your personal investment policy?

Hopefully, you examined the balance in your portfolio when the market was peaking, and made sure that you had adequate amounts in bonds and money market. If not, you might want to make sure you do that now. This is not to abandon the market, but rather to make sure that you have the staying power to remain invested throughout the bad market and volatility.

And don't forget, if your advisor had seemed too conservative for you in 2006 and 2007, send him or her a thank you card. They may have been protecting you from your own enthusiasm.

Things are different this time. Closed credit markets are threatening to bring the US economy (and all others by extension) to a grinding halt.

But remember, nothing lasts forever and better times will return eventually. The important thing is to look at your time horizon for your investments. If you have the staying power, then stay the course and remain invested according to your own personal optimal asset mix. If you don't have the time, then make sure you have enough money off the table to tide you through.

David Christianson is a fee-only financial planner and investment counsel with Wellington West Total Wealth Management Inc. and author of a certificate course for The Knowledge Bureau entitled The Structure of Client-Centred Practices.