How do you know if you're emotionally prepared for a market meltdown?

If you have money in the market, I hope that's a question you've at least considered.

Don't get me wrong. I'm not predicting a market meltdown is coming.

However, it would not be surprising if it happened.

Why?

That's what I want to talk about in this post.

I'm concerned for the thousands, potentially millions of newer investors who've never experienced this kind of market event.

We're going to look at some history, put some concrete numbers to what can happen, and talk about some behavioral science principals that may be able to help you.

The current bull market

According to this MarketWatch article, as of tomorrow, the current bull market, as measured by the S & P 500 index, which started on March 9, 2009, has avoided a decline of 20% or more for 3,453 calendar days.

There is an argument about whether or not that's the most extended bull market in history. Pundits love to argue about these kinds of things.

The answer depends on what counts as a bull market.

To me, it's a waste of time to argue. The point is, it can't go on forever.

J. D. Roth, one of my favorite bloggers over at Get Rich Slowly, recently wrote an article titled The Forever Fallacy. Here's the definition of the forever fallacy from the article:

The forever fallacy is the mistaken belief that you will always have what you have today, that you’ll always be who you are today.

My concern now, just like in the late nineties dot.com craze, is too many people think the current market conditions are the norm.

History, quite loudly, says otherwise.

Let's take a look.

History of bear markets

[socialpug_tweet tweet=”There have been two significant bear markets (declines of 20% or more) in the last twenty years.” display_tweet=””]

Look at the history with the following chart. The market used for this chart is the S & P 500.

As you can see, the chart goes back to 1926. The crash during the Great Depression was the worst in history, lasting 2.8 years and dropping -83.4%.

Looking at the five others before the bear market that began in 2000 might give you the impression that it won't happen again. And that may be true.

But what if it does?

We've had two significant bear markets in the last twenty years.

According to the chart above, the one that started in 2000 last 2.8 years with a cumulative decline of -44.7%.

The most recent happened during the financial crisis of 2007 and 2008. The results are below.

Measuring from these dates shows a decline of the S & P 500 of -56.4%!

Percentages are misleading. What matters is money.

Let's say you had a portfolio of $100,000 and stayed invested. In March 2009, that portfolio is now $43,600. For those of you with $1,000,000 portfolios, your value becomes $436,000.

If you had money in international and emerging market funds (and you should), your losses were probably over 50%.

Related:

Protect Your Investments in a Volatile Stock Market

How to Survive a Market Crash

It's more than a concept

The blogosphere is full of young investors talking about what they will do when the market crashes.

I hear things like, “everything's on sale, I'll be buying.” Or “I'm in it for the long term. What happens in the short term won't affect me.”

That's cool. And those are great and sound concepts.

[socialpug_tweet tweet=”Buying low and selling high is the winning strategy in market investing. Until it isn't.” display_tweet=””]

I've shown this chart in previous posts because it's instructive. Looking at the negative returns during this short period is dizzying.

Some might say, ” yeah, but look how the markets came roaring back.”

True enough.

Nowhere to hide

What the chart doesn't show is the constant drumbeat of media hour after hour, day after day, on every channel imaginable, financial or otherwise, saying that this was going to be as bad or worse than the Great Depression.

Here's an Investopedia article that offers a summary of the events. There's a short video (2:05) at the top that's worth the time.

From the article:

August 2007: The Landslide Begins

It became apparent in August 2007 that the financial market could not solve the subprime crisis on its own and the problems spread beyond the UnitedState's borders. The interbank market froze completely, largely due to prevailing fear of the unknown amidst banks. Northern Rock, a British bank, had to approach the Bank of England for emergency funding due to a liquidity problem. By that time, central banks and governments around the world had started coming together to prevent further financial catastrophe.

The Fed started slashing the discount rate as well as the funds' rate, but bad news continued to pour in from all sides. Lehman Brothers filed for bankruptcy, Indymac bank collapsed, Bear Stearns was acquired by JP Morgan Chase (NYSE: JPM), Merrill Lynch was sold to Bank of America, and Fannie Mae and Freddie Mac were put under the control of the U.S. federal government.

By October 2008, the Federal funds rate and the discount rate were reduced to 1% and 1.75%, respectively. Central banks in England, China, Canada, Sweden, Switzerland and the European Central Bank (ECB) also resorted to rate cuts to aid the world economy. But rate cuts and liquidity support in itself were not enough to stop such a widespread financial meltdown.

Why this matters

I bring this time up because it's the most severe recent crisis the world's endured.

[socialpug_tweet tweet=”I'm concerned that many investors, young and experienced alike, have forgotten what this period was like.” display_tweet=””]

It's tough to keep your head when everything around you is telling you the financial system is about to collapse.

Why? Emotions.

Decision making

Daniel Kahneman in his book, Thinking, Fast and Slow, describes the two decision making parts of the brain. He calls them System 1 and System 2.

The System 1 portion is the intuitive, fast thinking, emotional part of the brain likely to jump to conclusions without analyzing the data.

System 2 is our slow thinking, logical brain. And System 2 tries to manage System 1 to keep it from making impulsive decisions.

We'd like to think our System 1 rational brains would guide us to make the right decisions in times of high emotion.

Market history would indicate that's not the case.

During the latest financial crisis, investor money poured out of stock funds and into bonds, primarily Treasury and Government securities.

Emotions trumped logic.

One of John Maynard Keynes', (the noted British economist) most famous quotes says,

“The markets can remain irrational longer than you can remain solvent.”

It's great to say you can hang in there. I hope that's true.

But what if you can't?

For further reading:

What You Need to Know about Evidence-Based Investing

Here's How to Build an Evidence-Based Portfolio

Behavioral traps

Here are three behavioral biases that can derail your rational decisions in a market meltdown. I chose these three because to me they're closely related.

Anchoring – Anchoring refers to our tendency to attach or anchor our thoughts on a reference point. It can cause us to rely on one piece of information, often the most recent, when making decisions about things. Anchoring often occurs when learning concepts that are new. In many cases, the thing to which we anchor isn't always rational or accurate. Think about that regarding the markets and investing. The last ten years is most unusual. If you're anchored to the idea that you can withstand a market downturn but have no experience to back that up, it could cause you to react badly. Recency bias – Recency bias is our tendency to project recent events into the future. Related to the Forever Fallacy, we don't think about how long the current events will last. What if we anchor into an opinion we can withstand a market crash based on this recency bias? It could be a recipe for disaster. Imagine what you would feel like if your thinking on the topic got shattered ion a market meltdown. Adrenaline generated by fear of watching your portfolio halved raises your emotion to a level that causes a flight or fight reaction. We saw it happen to millions of other investors in dramatic bear markets. It can happen to you. Confirmation bias – In my unscientific opinion, confirmation bias causes more problems than any other behavioral bias. Confirmation bias happens when we've convinced ourselves that we've gathered all the necessary information to come to a particular conclusion. We start with the idea that what we believe is accurate. We then collect data from various sources to validate that opinion. The internet is a great place to confirm most any view. Confirmation bias snuffs out critical thinking. Without critical thinking, we will likely make bad decisions.

Behavioral science and economics

The field of behavioral science as it relates to economics has gone mainstream and become controversial, especially as it relates to the markets.

As an aside, I watched a debate between two Nobel Laureates, Eugene Fama, considered the father of the efficient market hypothesis, and Richard Thaler, a behavioral economist who believes emotions drive decisions and behavior.

Both are professors at the University of Chicago Booth School of Business.

It's a fascinating and very entertaining back and forth between two brilliant economists.

I've linked to the interview later in the post.

For further reading:

Steps you can take

[socialpug_tweet tweet=”If you haven't already done so, stress test your portfolio. Find out how it would behave in a worst-case scenario.” display_tweet=””]

The best and most recent example of this is the last financial crisis from October 2007 to March 2009.

I can't emphasize this enough. Part of being an intelligent investor is in understanding what kind of risk you're taking.

If your portfolio is up over 50% and it drops by 50%, a 50% gain doesn't get you back to even.

Why?

Here's that math:

Starting value – $100,000

Value after 50% gain – $150,000

Value after 50% loss – $75,000

50% gain on that – $112,500

It takes a 100% gain to get back the loss on the $150,000! At a 7% annual growth rate, it will take you ten years to get back to where you were!

Wouldn't it make more sense to manage the loss by reducing your exposure to the stock market?

Here's a table showing various losses and the return needed to get back to even.

The time needed depends on the annual percentage earned. Keep in mind, that using a constant yearly interest of return is not what happens in the real world.

Volatility changes it.

For illustration purposes, though, let's assume that 7% annual return and look at the 30% loss row.

Beginning value – $1,000

After 30% loss – $700

Gain needed to get back to $1,000 – 42.6%

Time at 7% constant return – 5.27 years

By limiting the downside risk, you reduce the recovery time by almost half.

How to reduce risk

In a market-based portfolio, it's pretty simple. You add bonds to the mix.

What type of bonds?

My advice is short to intermediate term, high-quality bonds. The most conservative choice is Treasury and government securities.

In a market meltdown, investors quickly dump their stocks and move into safe-haven bonds like Treasuries.

Basic economics of supply and demand means that when something is in high demand, supply shrinks and prices go up.

So when the market is tanking, this part of your portfolio offsets those losses. That's how you reduce your downside, and the time it takes to recover.

Fund options

Intermediate-Term:

Vanguard Total Market Bond Fund (BND) – It's an intermediate-term fund that replicates the US bond market. It's mostly government and high-quality corporate bonds.

iShares Aggregate Bond Fund (AGG) – Similar to BND with a slightly different approach. Both represent the US bond market and are intermediate in duration and maturity.

Short-Term:

Vanguard Short-Term Bond Fund (BSV) – This fund seeks to mirror Barclay's 1-5-year government/credit index. It's 65% government with the rest high-quality corporate.

iShares Core 1-5 – Year US Bond (ISTB)

There are numerous options out there. I didn't show these because they have the best returns.

I don't look to bonds for returns but as a type of portfolio insurance. Gains should come from stocks.

A caution on bonds

Too many advisors (and some investors) chase returns in bonds. Many go after high-yield (a.k.a., junk) corporate bonds or even emerging market bond funds.

That's a horrible idea!

The risk you're taking on these investments is similar to that in stocks. The problem?

The returns are not.

And unlike traditional government and high-quality bonds, changes in interest rates are not the primary driver of risk in high-yield bonds.

Because they are tied to lesser quality businesses who have to pay a higher rate of return to track investors, economic conditions have the highest impact on downside risk.

And isn't that the same for stocks?

Fixed income should not have an economic risk.

I'd prefer to take that risk in stocks where risk and return are more commensurate than taking a flier on high-yielding bonds.

The same holds true for floating rate and other non-traditional types of bonds.

Get your returns from stocks. Use bonds as a cushion in bad markets.

Final thoughts

If all of your investments are in the stock market, I hope you will consider what you've read here. Stocks offer some of the highest expected returns. They also come with the highest risk. And that's the way it should be.

I'm certainly not suggesting that you sell half your portfolio and put it into bonds. I am suggesting that you consider the impact of a 2008 type of financial crisis and market meltdown. Prepare yourself emotionally by putting your portfolio through a stress test. If you invest with Vanguard or most any other fund company, they offer tools to help you run this type of analysis.

A day of reckoning is coming. It could be tomorrow, next year or 10 years from now. Bear markets are part of the investing package. History (not just recent) shows that to be true. If you've been investing for the last ten years or so, it's likely you've had a cumulative growth of over 50%. Protect that gain. Add some portfolio insurance by including some high-quality bonds.

When the meltdown comes, you will be happy you did.

Now it's your turn. Do you have bonds in your portfolio? Have you put your investments through a stress test? Are you prepared to lose 50% of your money? Let me know what you think in the comments below.