By Mark Hulbert, MarketWatch, July 31, 2019
Perhaps the most important key to the long-term success of your stock market strategy is whether you will stick with it through a bear market. That’s because you can have the theoretically best strategy on the planet and still lose money if you bail at the bottom of the next bear market.
Yet determining your bear-market behavior is surprisingly difficult. Most investment firms try to do this by asking you to fill out one of the many “risk” questionnaires that may vary slightly in detail but for the most part are identical. They ask questions such as the length of your investment horizon and whether you worry more about not losing money than about not making lots of money.
These questionnaires are next to worthless, since we don’t know ourselves how to answer these questions. While we may genuinely think we will have the discipline and intestinal fortitude to stick with our strategy through thick and thin, the truth is that almost always we’re wrong.
Interestingly, most everyone at least implicitly recognizes how worthless those questionnaires are. Wade Pfau, professor of retirement income at the American College of Financial Services, recently conducted a survey of attitudes towards risk questionnaires and found that 95% of financial professionals found them ineffective, while 82% of individual investors shared that belief. (He reported these results in the latest issue of his Retirement Researcher newsletter.)
Why, then, are these questionnaires so ubiquitous? Pfau suspects that they continue to be used primarily out of convenience: “Risk questionnaires are used largely to ‘close prospects’ into an investment portfolio and subsequent advisory fee… The risk questionnaire is used by the advisor more for documentation on ‘suitability’ of why the client is in a portfolio rather than on the merits of the questionnaire’s validity.”
A far better indication of how you will react in the next bear market is how you behaved in the last bear market. If it’s applicable, go back and see how you actually behaved in the 2007-09 bear market, for example, during which the S&P 500 lost 57%. How much lower was your equity exposure at the March 2009 bottom than where it was at the October 2007 market top?
There is no shame in realizing you don’t have the stomach to stick with an aggressive strategy through a bear market. The only shame, if there is any, is lying to yourself about it.
My hunch is that you will discover that you don’t have the discipline and courage to stick with a fully invested posture, or any aggressive strategy for that matter, through a major bear market.
If that’s the case, then trim your equity exposure now, when the stock market is at or near all-time highs, rather than wait until the bottom of the bear market to throw in the towel. You will forfeit some gains to the extent this bull market continues, but you will be far better off over the long run.