Investing During Bear Markets

Reader Question

Why is it so difficult (for some of us, anyway) to invest in equities at an apparent market bottom/time of economic calamity, when one's intellect advises us that it would be logical and beneficial to do so? I remember in March 2009 I actually had a decent amount of available cash and I remember thinking to myself putting it into equities would be the smart move, but I just couldn't bring myself to do it. I think partially it was just irrational fear, but part of the fear was actually rational since I have a very irregular income, and I wanted to make sure I had enough cash to tide me over for a couple of years if need be. The way things played out with the V-shaped market bounce back, it looks like I made a huge mistake. But is that just 20-20 hindsight? Why is this so difficult?

My Reply

That's a great question. The answer is undoubtedly complex, with a few rational and plenty not-so-rational reasons. You've touched on a few of those already and I'll try to suggest some of the others.

First off, there's no question that some of it is 20-20 hindsight. Things could have turned out much worse than they have. The modern financial system is by its nature relatively fragile. It is built on debt and leverage. If there was no debt there would never be any chance of collapse of the financial system (in fact there wouldn't be much of a financial system, period). If there was no leverage then the amount of unpaid debt that could trigger a collapse would have to be huge. The fact that debt exists and the leverage magnifies it means that the system is fragile.

Before you jump to the conclusion that we must outlaw leverage and/or debt, keep in mind that the two are also in huge part responsible for making the United States and much of the rest of the world a great, wonderful, prosperous place to live. Without debt and leverage it would be impossible for vast majority of people to buy a house or go to college or for vast majority of businesses to form and grow. In all likelyhood humanity would be set back a few centuries if we never invented and adopted the modern financial system. By the way, the topic of gold standard is entirely orthogonal to the topic of debt and leverage, even though the two are conflated an awful lot. It is perfectly possible to have the gold standard and still have all the same ills (as well as benefits) of debt and leverage. In fact that was exactly the state of the financial system before the 20th century and the Great Depression and the inability -- or at least inflexibility -- of the gold standard to deal with those ever-present panics and collapses is what caused the world to abandon it in the first place.

So debt and leverage are very much necessary and beneficial parts of our modern lives. I'll gladly take the occasional panic and even collapse over permanent subsistence living which (along with nearly constant state of war) was humanity's lot for millenia. But take on too much debt or too much leverage and things can get very dicey very quickly. Trouble is it's extremely, exteremely hard to quantify what constitutes "too much" debt or leverage. In fact it seems likely to me that there's no way to quantify it to any more precision than a factor of 2 or 3 (which is to say it's unquantifiable for all practical purposes). All we can do is fly by the seat of our pants, hope for the best and occasionally deal with the worst. That worst is exactly what transpired during the housing bubble and the subsequent collapse. In the bigger picture, the housing bubble was still in some ways just the tip of the iceberg -- all of the western world has been increasing its overall debt levels (relative to the GDP) for decades. Again, this has brought a lot of prosperity that would otherwise likely be unattainable. And again, nobody really knows whether these debt levels are going to prove to be too high.

Getting back to the topic of investing in bear markets... As is hopefully clear from the above, bear markets are a very real phenomena that necessarily relfect (and usually preceed) real-life economic troubles. Some of them, such as the Great Depression, can be much worse than what we experienced in 2008-2009. If the US ends up defaulting on its debt for whatever reason chances are high that we will see that "much worse". Even if you have a steady job and an emergency fund, one and then the other can disappear in a hurry in a truly bad downturn. So being afraid to invest more of the savings when the bear market is raging is not exactly irrational.

But there are plenty of irrational aspects to such fears too. Let's list out of some of these:

• External influences. During a bear market you will be bombarded with all sorts of fear-mongering from every angle. CNBC will be full of "experts" telling you how things will get much worse. The web will be full of outright end-of-the-world-as-we-know-it predictions (these haven't abated even during the currently ongoing bull market). Your neighbors and colleagues will be telling you how they pulled money from stocks to avoid even bigger losses. Some of these messages will be genuine expressions of concern and plenty will be just a way to make some money on fears of individual investors. But one way or another you will be subjected to a constant stream of negativity. As much as we like to think of ourselves as independent-minded and rational beings the truth is that we are very much affected by what we see, read, and hear.
• Extrapolation of current price trend. Even if you are able to completely tune out everyone else's opinions you will still have your own brain to contend with. We naturally see and recognize patterns everywhere, whether they are real or not. Pattern recognition is an incredibly useful skill and may well be the "secret" to our intelligence and creativity. One of our favorite patterns is projecting (recent) past experiences into the future. For the most part it works quite well. Your life over the next year will probably be a lot like your life over the past year. The year will still have four seasons. Reality shows won't disappear. Electronic gadgets will continue to improve. And so on. But once in a while such projections lead us astray, with extrapolation of current price trends into the future being the most obvious in the context of investing. A whole "science" (and I use the term very loosely) of technical analysis is built on this with barely a shred of evidence that it works even before frictional costs, let alone after them. Everybody knows to "buy low and sell high" but the most popular way to "analyze" the markets -- technical analysis -- essentially advises you to do the exact opposite on the premise that the current trend will continue into the future. That would be lovely if it were true but as far as I know the people who become rich on technical analysis are the ones who sell their books, newsletters, and programs -- and not those who actually use them. Since there are literally tens of millions of investors worldwide who follow technical analysis in some form it is statistically inevitable that some of them strike it big. But your average technical analysis devotee will find his results to be very disappointing over his investing lifetime. So why does technical analysis remain so popular? One reason is that it looks highly scientific while remaining easy to do (especially in today's computer age). The bigger reason, in my opinion, is that it dovetails so well with our innate tendency to recognize the downward (or, for that matter, upward) price trend and project it to continue in the future. Why hold something that's bound to keep going down? And why not buy into something that's bound to keep going up. The reality however is that markets are under no obligation to honor such patterns. Short-term price movement in liquid markets (which is what vast majority of investors apply technical analysis to) is random for all practical purposes. It's not really random of course, but it's so difficult to analyze that it might as well be. It's certainly not going to be as simple as "buy when the 50MA crosses above 200MA on increasing volume". The price patterns that we all see and that technicians obsess over are illusory figments of our overactive pattern-recognizing brains.
• Fool me once... No bear market goes straight down (with the exception of Black Monday of October 1987, I suppose). It has plenty of twists and turns which will likely see you put in some new money, watch it go up a bit and then plunge way below your purchase price. This was certainly true in the 2008-2009 bear. After a few of such "bargain-priced" purchases anyone will become hesitant to buy again. It's really just another example of our tendency to extrapolate the current trend into the future. Every time you bought you got burned, so, your brain is thinking, maybe it's time to stop buying?
• Greed. As cheap as equities were in early March of 2009 they have been even cheaper (on valuations like P/E, P/E10, and dividend yield) at bottoms of some other bear markets (1932, 1982). In fact plenty of "experts" were pointing that fact out in early 2009 as a reason to not buy just yet. Of course, the fact that something has been even cheaper once upon a time (and both 1932 and, especially, 1982 cases happened under very different circumstances) doesn't mean the market is obligated to reach those depths again. Everyone knows that buying around the 1932 or 1982 bottoms proved to be extremely lucrative and enough people may well decide to settle for merely very lucrative bird in the hand instead of holding out for extremely lucrative two in the bush, thus arresting the slide before it reaches 1932/1982 levels.

So it's definitely a combination of rational and irrational reasons that makes it hard to buy during the depths of bear markets. This is yet another good reason to hold bonds -- they will both cushion the blow to your portfolio value and provide "dry powder" with which to buy beat-up equities. Yes -- today's bonds won't bring nearly as good returns as they have over the past 30 years, but you sure will be glad you have them when the next bear market strikes.

I have no idea when that next bear market will come or how severe it will be but it is almost a sure thing that at some point in your life you will again experience at least one bear market that resembles -- or even exceeds -- 2008-2009 in severety and scope. Keep this discussion in mind when that time comes.