How to Deal with Losses in the Market

Man oh, man! We're in the midst (some would say near the end) of the one of the longest U.S. bull market in history.

Losses have been minimal. But at some point, the market will take back some (or a lot) of what it's offered in the last 11 plus years. Are you prepared for it? Have you thought about it? Do you have a plan in place to mitigate, or better yet, profit from the losses?

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

Losses are part of the picture when investing in stocks, real estate, commodities, and other volatile assets. Investors who have been around for more than this bull market understand that very well. I've said it many times in the past. Risk and return are related. If you want higher expected returns, you have to be willing to accept higher than expected risk. There's no way around it.

Product Manufacturers

Firms will try to convince you they have a better mousetrap and can get you a higher return without the higher risk that comes with them. Product manufacturers (mutual funds, ETFs, brokerage firms, etc.), produce these products most often shortly after a significant market drop.

They prey on the fear investors feel after enduring one of these adverse market events. It's textbook advertising strategy.

Numerous studies confirm that the fear of loss is two to three times higher than the joy that comes from the reward. Advertisers and investment product people know that. It's no accident they produce most of these “risk management” product shortly after a significant market drop.

I was an advisor at a couple of those firms during two of those significant drops. More on that shortly.

My goal today is not to predict when the next bear market or recession is coming. People much smarter than I have tried and failed at that numerous times.

No. My goal is to encourage you to think about what happens to your portfolio if the market drops by 20%, 30%, 40% or more. How will you deal with the paper losses? Will you panic? Invest more? Will you try to time the market and get out before it drops?

Investors have done all of these things in past bear markets. A precious few have lucked into success. it reminds me of the old saying, “even a blind squirrel finds a nut once in a while.” The evidence suggests that no one has any long-term success at it.

My advice. Forget about trying any of those strategies. I'll offer my thoughts on the best way to manage and profit from the losses you see on your account statements in a bear market.

A History of Losses

As a financial advisor, I've been through three of the more significant downturns in the market. I started as a stockbroker in November 1987. Yup. That was a VERY long time ago. For those who weren't around or don't remember, on October 22, 1987, the market dropped 22% in one day. That was the unofficial introduction of “programmed trading” into the markets.

Programmed trading happens when traders set up electronic triggers, usually based on stocks or markets reaching a specific price, that automatically execute large-scale buying or selling of stocks. That's what happened in 1987. The total loss for the period from August 1987 to December 1987 was 33.5%.

The next and more significant drop was from 2000 – 2003. During that period, which lasted 2.1 years, the market dropped -44.7% for an average annual decline of 24.8%. Many of you weren't around for this one either.

I suspect most of you were around (at least alive) during the last major crisis of 2008. It started in 2007 and ended on March 9, 2009. We call it the 2008 crisis because that's where most of the damage occurred. That bear lasted 1.3 years with a total market drop of 50.9%. With just a 1.3 year duration, that's an average annual return of -41.4%!

The following chart from First Trust Advisors shows the history of bull and bear markets since 1926.

Image of a graphic chart showing all bull and bear markets from 1926 to June 2019
Source: First Trust Portfolios

Gains Follow Times of Losses

There are several things we can learn from the chart.

  • Periods of significant gains follow periods of substantial losses
  • In most cases, the gains that follow are much higher than the losses that preceded them
  • The average length of time of the gains following the losses is longer than the preceding average period of losses

First, let me start with the disclaimer (don't you hate these?) – past performance does not predict or in any way guarantee future returns or performance.

However, there are lessons to learn.

  • Gains follow periods of losses
  • The time length of the periods of increase is longer than the preceding periods of loss
  • The percentage of gain (both cumulative and average annual) are higher than the previous periods of loss

The Greatest Antidote for Losses – Time

Have I mentioned that you should NOT invest in the stock markets for short periods? I guess I just did! It's a lesson often forgotten by investors. It's a lesson that can have severe negative consequences if ignored.

Why?

Let's say you invested $50,000 in stocks 2007 with the intent on taking the money out for a downpayment on a new house. You put 100% of that investment into the S & P 500 (which is what the chart represents). You projected a “conservative” return of 7% which would turn into just over $70,000 in five years. Instead, that $50,000 lost half its value and is now worth less than $25,000.

If, on the other hand, you left the money invested during this current bull market, your $50,000 would now be worth somewhere in the neighborhood of $123,000. No one should invest in stocks and plan on using the money in five years. Stocks are long-term investments.

You can see in clear illustration what would happen to someone planning on buying a house with money they invested in stocks for five years. If you plan on using the money to buy something, keep it in a short-term, low risk (or FDIC insured) account.

The example also assumes no additional money came into the account. Had the investor added money during the 2008 financial crisis, the ending value would have been even higher. Famed investor Warren Buffet says, “Buy when others are selling. Sell when others are buying.” He has become one of the wealthiest men in the world following his advice.

Disclaimer: Keep in mind, these are only estimates. We would need to know the exact date of the original investment and the exact date of the current value. We assume it was sometime in 2007 and there no new money came into the account. Returns come from the First Trust chart listed above.

Noncorrelated Assets

Anyone invested in the 2008 meltdown remembers how everything they owned seemed to go down at once. Investors who thought they had diversification quickly discovered they weren't as diversified as they thought. Whether you had U.S., international, or emerging market stocks,  everything went down dramatically.

So what can investors do? Add noncorrelated assets. That means adding things that go up, or at the very least, don't go down, when stocks fall.

Treasury and Government-Backed Securities

Treasury securities, either directly purchased or via funds and ETFs,  are not correlated with stocks. Those who had Treasuries and other government bonds in their portfolio had much smaller losses than those who didn't. Corporate and high yield bonds did not provide the cushion that government bonds provided. If you're invested in an all-stock portfolio, consider adding some Treasury securities.

Real Estate

Reals estate is another asset class that is often not correlated with the stock market. If you have the cash and inclination to do so, rental properties can be an excellent real estate investment. You don't have to watch them go up and down like the stock market. They are not liquid. You can't sell them quickly for cash. Depending on the market, they can provide nice growth without the volatility of stocks.

Another way to invest in real estate is through real estate investment trusts. Called REITs (pronounced REETS), these can be in the form of publically traded or private securities. Publically traded REIT's are more income-oriented than growth. They are a good option for an asset that is not highly correlated with stocks.

Private REITs are another excellent option. These REITs have recently become available to smaller investors through crowdfunded REITs. One of the more popular options comes from Fundrise. They offer income, income and growth, and growth options. They've been around longer than most other crowdfunded REITs.

A newer fund to consider is DiversyFund. Their DiversyFund Growth Fund has one goal in mind – growth. They have a particular type of property they look for (multi-family units) and a precise way to buy and improve them. Though that's the only option available now, if you're looking for a real estate investment to grow, consider the DiversyFund Growth Fund.

Keep in mind that these private REITs are not liquid. Access to your investment is limited. Count a minimum five year holding period for this money. Alternative noncorrelated assets like real estate should be a small part of the portfolio for most investors. Along with government and treasury securities, they can offer a cushion to your portfolio in a falling stock market.

The Incremental Process to Mitigate Losses – Rebalance

Rebalancing is something we hear a lot about with little explanation about how/why it works. It starts with an asset allocation strategy. That strategy sets target percentages for each asset class in the portfolio (stocks, bonds, cash, etc.). At its core, rebalancing means selling assets that have increased above a target percentage and buying assets that have fallen below the target level.

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Final Thoughts

Investing can be as simple or complicated as you want to make it. The best way to invest at the lowest costs is with index funds. Whether you are a newer investor just starting or a seasoned investor who's been investing for decades, it pays to review your goals and strategies regularly. Why? Circumstances and life changes happen. The goals you set for your investments initially may have changed.

Never invest in stocks for the short term. No one wins that way. As I hope we've illustrated, the losses can be devastating. Short term money should not be in the market. Forget the return your losing. Think about the principle you could lose.

Will Rogers said, “The return OF my money is more important than the return on my money.” Many investors got hit with heavy losses trying to chase returns from the hot stock or fund. It's a losing proposition.

Take the long view. There is money to be made in the markets over long periods.

  • Set your asset allocation.
  • Put target high and low percentages around those targets.
  • Rebalance when they get outside those targets.

Then sit back and watch the “pouting pundits of pessimism” (a quote from Brian Wesbury) tell you how bad things are and how much worse they're going to get. After all, bad news sells. Good news is not newsworthy. Turn off the financial press (unless it's for entertainment), sit back and relax, knowing your plan is in place and you've set yourself up for the best chance of long term success.

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