After surviving a few bear markets over the past 40 years as an investor, I’ve learned many lessons from them.
Reducing risk in stocks before bear markets take full hold helps investors protect their net worth as well as have capital to invest in stocks again once unusually low valuations are reached.
This sounds almost too obvious to write, but most investors don’t take steps to reduce risks in stocks simply because of lack of clarity about what works.
By seeing what other strategies known to reduce risks in stocks have done in past bear markets, we can see what has the highest probability of reducing risk again.
As always here at Retire Certain, considering probable outcomes (probability) and using historical data and facts helps us investors reduce risk while building wealth.
Bear Markets Cannot Be Perfectly Timed
Bear markets begin before it is officially known that they have begun making it impossible to predict the exact time a bear market will begin.
This means that the timing of buying assets that go up when stocks go down will be imperfect but can reduce risk and build wealth by capitalizing on broad cycles, nevertheless.
Instead of trying to pick exact market tops and bottoms, we can look at valuations and overall economic and market cycles as addressed throughout this post.
Value investing is a natural ways for reducing risk in stocks. Proactive investors, for example, can lower risk by logically easing out of overvalued markets and into assets that go up when stocks go down.
Value investing reduces risk because it forces investors to buy assets cheap. It is commonly said that the money is made on the buy side.
This means that when you buy an asset below it’s value, you naturally have a lower risk.
Re-balancing for Reducing Risk in Stocks
Easing out of overvalued assets happens naturally with annual portfolio re-balancing between stocks and bonds. This may not lower investment risk enough, however, for investors with a low risk tolerance and older investors, as addressed more ahead.
The Need for Reducing Risk in Stocks Is Increasing
It concerns me that bear stock markets have increased in severity over the past 2 decades with the Nasdaq dropping over 60% in the tech bubble and the S&P 500 dropping 56.4% in the financial crisis related bear market.
I can’t help but wonder if this is due to electronic trading, but then, in the bear market of December had a mild drop of 20%. The market, however, never dropped to low valuations. Also, a drop of 20% or more is required for a correction to be considered a bear market, so it was just barely a bear market (forgive the pun). (1.)
This higher bear market severity from the 2000s decade has increased the need for risk adverse investors to lower risk by investing more money in assets that go up when stocks go down, using stop losses or increasing cash based on high valuations in my humble opinion.
High Net Worth Investors Demand Risk Reducing Strategies
Wealth managers for high net worth clients reduce investment risk as stock markets become pricey. Individual investors can do the same themselves or with a financial advisor by investing in assets that typically go up when stocks go down.
History Reveals Methods for Reducing Risks in Stocks
Investing in assets that went up during past bear stock markets is logical. It helps protect investors from emotional decisions that increase investment risk.
Riding Out Bear Markets
Long term passive buy and hold investors using an asset allocation strategy may wish to ride out bear stock markets. This strategy works well when you have several decades to accumulate wealth, or when you happen to buy into the market at low valuations anyway.
Reducing Stock Risk By Chance
For example, picture a passive investor that inherited a large amount of money in 2010 and invested it all in stocks. She is feeling pretty brilliant 8 years later when he stocks have more than doubled.
But what if that same investor inherited money in early 2007. She was feeling pretty incompetent five years later when she was just getting back to break even after a lot of financial stress along the way.
She unknowingly bought into low stock valuations thereby unknowingly reducing the risk in stocks.
Most investors that adhere strictly to an asset allocation model probably already own US Treasury bonds which usually go up when stocks go down as covered more below.
Bear Markets Affect Net Worth
Investors are encouraged to ride out bear markets. “Riding out” large stock market declines can have a significant damaging impact on net worth until the stock market eventually recovers.
Riding out stock market declines, however, is much better than selling near markets lows and buying stocks again high based on emotions.
The best strategy is to plan ahead for bear stock markets and make adjustments beforehand or early on if they are going to be made at all. Knowing what goes up when stocks go down based on bear market history is a great place to start.
How the Best Investors Reduce Risks in Stocks
We can look to the best investors to see their strategies for reducing risks in stocks.
The wisest investors (and many high net worth wealth managers) buy assets that go up when the stock market goes down before the market crashes.
Note that they are often early and thus get criticized brutally for imperfect timing. It’s better to be early to the party than late, however.
Some examples of “wise investors” I notice are:
1. Ray Dalio
Ray Dalio predicted the financial crisis and helped the White House during the financial crisis.
Here is a super video on the actions of Dalio and his associates before and during the financial crisis.
(I have no affiliation whatsoever with Bridgewater and am not paid to have this video here, I simply want to provide reliable investing education.)
Ray Dalio Financial Crisis 2008
Mark Baum who predicted the financial crisis and made money by investing on his insights. His story is told in the book The Big Short.
If you love movies like my family does, and want a short cut, watch the movie. It’s a great movie for older children, too. (I don’t recall the language so check ratings first if this is a concern for you.)
3. Warren Buffett
Legendary investor Warren Buffett. While Warren is known for long term investing, in August 2019, for example, Berkshire Hathaway’s quarter 2 operating results revealed a record high level of cash.
As closely as he is followed by investors, Warren is very careful not to spook the markets with his words and actions. Berkshire’s operating results, however, allow investors to see how he is investing.
It’s important to point out that Warren is at least as much an entrepreneur as an investor. He finds undervalued companies and buys significant positions in them.
By doing this, he influences the management of the companies in which he invests, thereby almost always increasing profits.
I think of Warren as a rainmaker, which is someone who comes into a company and increases profits.
He makes money on the stocks because he makes changes at the companies.
Warren begins by buying undervalued stocks.
Charlie Munger finds the undervalued stocks to buy, and Warren goes in and usually increases company profits. (He has had a few failures but not many. I am not aware of anyone with a perfect investing history.)
Diversifying Partially Reduces Investment Risk
The common practice of simply diversifying into assets that go up when stocks go down, such as U.S. Treasury bonds, offsets at least some of the risk of losing money from stock market crashes.
But investing in bonds before a bear market doesn’t completely prevent losses in investor’s portfolio for most asset allocation investors and here’s why.
Higher Stock Portfolio Allocations
Investors tend to have a higher percent of their portfolio in stocks than bonds. Recently, I worked with an older wealth coaching client whose financial advisor increased her stock allocation so she can “catch up”.
I am hearing this advice a lot in the media. It deeply concerns me.
Investors often have much of their bond allocation invested in bonds other than Treasury bonds in a desire for higher interest income. This is particularly true for investors living off income, who are often retirees.
Such bonds often go down in value during financial turmoil due to the higher risk from higher yielding bonds.
The reason US Treasury bonds go up in value is because investors flee to safe investments, and due to their inverse relationship to stocks. (Amazingly, with over $22 trillion in debt, the US government is still regarded as a safe issuer of bonds.)
Don’t take my word (or anybody else’s word) when you can “google it” for an instant answer.
Read my related post What Are the Risks of Bonds?
Bond Correlation to Stocks
Let’s see what the data shows about reducing stock portfolio risk with bonds from recent past bear markets.
For example, in 2008 when the S&P had a negative return of 37%, corporate bonds had a negative return of 2.76%.
Corporate bonds as represented in the Bloomberg Barclay’s U.S. Intermediate Credit Bonds Index fared better in 2002; they were up 10.14% in 2002 when stocks had a negative return of 22.10%.
In fact, corporate bonds had decent returns exceeding 9% in all three years related to the tech bust in 2000, 2001, and 2002 when stocks (S&P 500 index) had negative returns.
Stocks usually go down much more than bonds go up during bear markets and related financial turmoil.
For example, in 2008, when the S&P 500 had a negative return of 37%, U.S. government bonds had a positive return of only 10.43%.
In 2002, when the S%P had a negative return of 22.10%, U.S. government bonds had a positive return of 2.29%.
This data is based on the Bloomberg Barclays US Intermediate Government Bond Index which measures investment grade intermediate bonds. (2.)
Remember, returns include dividends or interest so part of the returns for both stocks and bonds includes dividends or interest.
Here is what I mean by this. Regarding bonds, in 2008 the prime interest rate ranged from 3.25% in January to 6.50% in December, so the interest income offset the drop in the value of the bonds.
Read my related post Risks of Income Investing.
Accepting Bear Markets Lowers Risk
Simply by accepting the fact that bear markets happen allows you to lower risk because you won’t freak out emotionally when they happen.
Bear stock markets are a fact of life for all stock investors. Accepting this and planning for it emotionally and strategically helps you invest smarter and with less stress.
By periodically estimating how a stock market crash will affect you from a net worth perspective, you will be better grounded in reality, and thus, prepared. This reduces financial stress.
Knowing what goes up when stocks go down and buying more of it near stock market tops can lead to making money in bear markets.
Increasing Cash Allocation in a Portfolio
Even if you only increase cash before stock bear markets, which is, believe it or not, an asset that goes up when stocks go down, you’ll have funds to buy assets cheap after or near the end of the bear market.
Increasing the cash allocation in a portfolio by selling some stocks as they become over valued is the easiest method for reducing risks in stocks.
Using Historical Facts for Reducing Risk in Stocks
Individual investors now have easy access to powerful information and data that was only available for financial advisors in the past if it existed at all. It’s ours for the taking to help navigate the financial markets.
There is simply no reason not to use this free information to reduce risk while building wealth.
Conservative Stock Myths
Another fact we know from past bear markets is that almost all stocks go down during bear markets.
A wealth coaching client recently told me that her financial advisor has her invested in “conservative” dividend stocks.
She’s a single, retired teacher and wants low risk investments.
“Conservative low risk stocks” just means that those stocks will probably drop less in bear markets. There is a prevalent misunderstanding about investment risk from dividend stocks.
Again, don’t take my word for it.
Let’s, instead, look at history, facts and data to estimate how much “conservative” dividend stocks will probably move in a nasty bear market similar to the past with Beta.
Stock Dividend Beta
Beta is a simple readily available and widely accepted tool that shows how volatile an investment is relative to another investment.
To measure stock risk, a stock index is used for the comparison foundation. (This is known as a benchmark.)
An index represents the overall stock market. The S&P 500 or the Dow Jones index are commonly used as benchmarks for US based large stocks.
The S&P 500 leans more toward growth stocks. The Dow is an older index and has a slightly higher dividend yield so it is used by Vanguard for the volatility comparison for the fund below.
So let’s do this quick little exercise to see how volatile dividend stocks tend to be relative to the overall stock market.
Note that the word “volatile” is the term established by mainstream financial services for the measurement the Beta reveals. I joke that volatile is a better sounding word than “falling”, but not as positive sounding as “increasing”.
Beta for Vanguard Dividend Stock Fund VYM
A popular Vanguard high dividend stock ETF, VYM, moves in relation the Dow Jones U.S. Total Stock Market Index by .86 based on the “Beta coefficient”. (Other dividend funds have Betas of over .90.)
While this term sounds intimidating, it is very simple. If you have $1,000,000 in stocks, and history repeats itself and the stock market drops 50% (the Dow Jones U.S. Total Stock Market Index) your stocks will drop by only 86% of 50%, or 43%.
Looking at the math, the million dollars in stocks would decline to $570,000.
This means that reducing risks in stocks is only partially accomplished with dividend stocks.
Risk from Dividend Stocks Assessment
As of this writing, the “high dividend stock” ETF was yielding about 3.29%. As an investor, I assess if such a yield is worth the higher risk when money markets are yielding over 2% without any risk.
Reducing Risk in Stocks Summary
Well, I promised myself this article would be under 1500 words and here I am at 2500 so I will end here.
But in good conscience, I needed to share everything here on what I’ve learned about reducing risks in stocks.
I don’t know about you, but the older I get the less investment risk I want.
How do I know about reducing risk in stocks? Been there and done that, both alone and with financial advisors.
Understand investing enough to invest within the risk level you choose or enough to hire a financial advisor who will really do it for you.
Yes, you choose your level of investment risk and invest accordingly. But I’ll save that for another post. Thanks for reading and please share this article on social media if you think others may benefit from it.
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Disclaimer: Nothing in this post is meant to be taken as personal financial advice. Only you are responsible for your own money.
1. Historic bear markets – http://www.nbcnews.com/id/37740147/ns/business-stocks_and_economy/t/historic-bear-markets/#.XUnBuuhKjcc
2. Asset classes performance history – https://www.mfs.com/content/dam/mfs-enterprise/mfscom/sales-tools/sales-ideas/mfsp_20yrsf_fly.pdf