Coping with bear markets and stock market falls

Bear Essentials: How I Approach Stock Market Falls

Reading time: 4 mins

We’re currently in ‘correction’ territory with the UK market down 10% from its most recent peak in May 2018. Stock market falls like this can hit investment trusts harder than most, as a lot of funds have some level of gearing and discounts to asset values tend to widen.

I’ve recently put some money into the market. Not a lot, but enough to have me rolling my eyes and thinking why didn’t I sit on the cash for a little bit longer.

It’s at times like these that I like to refresh myself about a few fundamentals about stock market history. If nothing else, it can stop me from making any rash trades when my emotions are riding high!

Twice the pain

You’ve probably read that price falls hurt more than twice as much as the pleasure you receive from an equivalent price gain. In fact, it’s been measured at 2.25 times. This phenomenon is known as loss aversion.

With each market fall of this magnitude I experience, I think they have become a little easier to cope with. That’s not because they hurt any less, but I’ve got a little bit better at appreciating that it’s just the way the stock market works.

Morgan Housel, a well-known US commentator, has done some excellent work on the regularity of stock market falls:

Markets crash all the time. You should, at minimum, expect stocks to fall at least 10% once a year, 20% once every few years, 30% or more once or twice a decade, and 50% or more once or twice during your lifetime. Those who don’t understand this will eventually learn it the hard way.

I think investors should have that middle sentence committed to memory. It’s a great reference point for how frequent these sort of falls are.

However, although we know that the market will have these falls on a fairly regular basis, we never know when they will take place.

What’s more, markets seem to rise slowly but fall quickly. Loss aversion, therefore, dictates that we hardly notice the gradual gains but that falls can be seared into the memory.

The financial press does their best to spook everyone, too. Bad news sells, so they roll out the “UK stock market loses £.. billion” headlines.

How has the UK fared?

I’ve created the following chart which shows how far the UK stock market has fallen from its previous all-time high. It’s measured on a total return basis, so it includes dividends as well as share price movements.
UK stock market drawdown from the previous peak
Click to enlarge

Now that I think about it, this chart pretty much spans my active investing career. I owned some privatisation shares in the 1980s but basically left them to do their thing up until the mid-1990s.

Over this period, the UK market has been within 5% of its all-time high almost half the time. In other words, the fact the market is near its all-time high shouldn’t put you off making a long-term investment. Stock markets regularly make new, all-time highs — it’s kind of their thing.

At the opposite end, being 20% or more off an all-time high is relatively rare, accounting for just under a sixth of the period I looked at.

Reliving the big bears

I don’t remember much about the fall in 1994 and 1995. I was just getting started and my portfolio was pretty small at the time.

That sharp spike in 1998 is another matter. It was the Asian crisis/Long-Term Capital Management debacle and I remember that I was working abroad for about a month in a very remote area. I got a copy of the Financial Times at the airport on my way home and got a nasty shock when I checked the share price pages!

The dotcom bust was a biggie. But when you include dividends, it took just five years or so for the market to hit a new all-time high. That was a weird bear market, though. Old economy stocks actually did really well but anything remotely associated with technology got hammered.




The hardest market of all

The financial crisis of 2008/2009 was the toughest market I think I’ve ever faced. Everything fell. And really quickly.

I was writing financial articles throughout this period, struggling to make sense of how it was all playing out. For a few months, it really seemed like the whole financial system could come crashing down.

By the way, if you haven’t read Alistair Darling’s ‘Back From The Brink’ on how we muddled our way through this period then you really should. Don’t read it late at night as it’s terrifying in places!

How have we done since the last crash?

Since the financial crisis, we’ve had a number of sizable market falls here in the UK.

We’ve had three drops between 15% and 20%, in 2010, 2011 and 2016. Then there have been five of around 10%, in 2012, 2013, 2014 and now twice in 2018.

That’s eight 10%+ drops in the last nine years and that’s pretty much par for the course.

So, what happens next?

As I’m writing this, the UK stock market is rebounding a little, but I’ve got no idea where it might head next. Neither does anyone else of course, no matter how smart they might sound.

Historically, 10% falls seem to turn into 20% falls about half the time. Of the last eight 10% falls, we have had three that have gone on to hit the 20% level or thereabouts.  Of course, the last of those eight is still in progress, so only time will tell how it actually plays out.

You could argue that the fact we’ve had two 45% declines in the last twenty years means that another really big fall right now is unlikely.

Perhaps.

The trouble with stock market data is that we don’t actually have a great deal of it. Decent records go back about a century or so, although the stuff that’s readily accessible on the Internet tends to be only two or three decades.

And although we can say what has happened, it’s only a rough marker post for what to expect going forward.

If…

How you react to falling share prices should be your own decision of course.

If you intend to stay invested for a long time, as I do, then most people would argue that you should stay the course. Selling after a heavy stock market fall and then being too afraid to buy again can really destroy your wealth.

If you’re hoping to cash in over the next few years then hopefully you’ve already begun the process of moving into less risky investments. In that case, the effect of any stock market fall should be muted somewhat.

If you find that you’re rethinking your investing strategy simply because the market has fallen a little, then I think it’s time to go back to the drawing board. You’re probably focusing too much on price movements at the expense of the underlying investment.

If you’re being really sensible, you haven’t been looking at your portfolio at all this past week and you didn’t know the market had fallen 10%!


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