All year I've wanted to write an article urging advisers and individual investors to prepare for the next bear market. When stock markets hit a pothole in late summer and early fall, it struck me as an opportune time to refresh this idea.
The decline from early September through mid-October was severe among Canadian stocks, which registered an 11 per cent decline. Below is a table showing returns of a selected list of asset classes during this recent period.
Canadian small-cap stocks, commodity stocks and some smaller foreign stocks were hit pretty hard but none were in bear market territory. Moreover, bonds were up by about 1 per cent – making for a very modest decline for balanced portfolios during this stretch.
While too much attention was paid to declines during this period, the way people worried can be a useful reference point to starting the bear market discussion. In a recent column for Investment Executive I tell advisers to remind their clients that bear markets are part of the investing process. What I didn't cover in the column was how specifically to speak to this issue with clients. The conversation need not be complicated.
I was in a client review meeting recently. Performance clocked in at about 8 per cent (net of fees) for this client's conservative portfolio over the past year. This client's target – i.e. the return needed to achieve his goal – is about 4.5 per cent. I explained that our initial expectation was for his portfolio to generate an average of 4.5 per cent per year (net of all costs) compounded over a long period of time. In year one we achieved 8 per cent but that we still expected the combination of this strong first year and future returns to average out to about his target return.
The average can fall from the current 8 per cent via a string of many lower-return years or (more likely) through the occurrence of another bear market. I didn't have these tables handy but I pointed out that bear markets have always happened and they likely always will. So another is coming at some point, and when it occurs our disciplined rebalancing will kick in at a relatively low point and trigger a rebalance out of bonds and cash and into stocks.
I warned him that it will be uncomfortable when a rebalance is taking place but that it will ultimately position the portfolio to recover more quickly and help increase the odds of hitting his long-term target. And in the meantime, we always 'carve out' a cash cushion to fund any shorter-term cash needs.
This client's bear market education will continue through future communications and meetings. And of course, when the next bear market materializes this client will be as well prepared as possible.