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 Bear Markets 

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How Common are Market Declines?

Periods of stock market decline are as natural as full moons, but not as predictable. In the 1990's, stock advances have been abnormally large and unusually persistent, declines have been rarer than their historical frequency and shorter-lived.

Why do markets decline? Some observers point to excessive security valuation, economic change, political change, or random unsettling events in the world. My suspicion is that human psychology -- playing off these triggers -- has a very large role. Just as people can get depressed after experiencing some peak of excitement or fulfilling a difficult goal, the markets people create can retrench after an exuberant climb.

How often do declines occur? How deep can they be? The following answers are taken from fifty years of Dow Jones Industrial Average ["DJIA"] data analyzed by Ned Davis Research (Wall Street Journal, 1994)...

Market Decline "Name"

Dip

 Moderate Correction Severe Correction Bear Market
Decline Threshold >= 5% >=10% >= 15% >= 20%
Occurrences in 50 Years 127 33 16 9
Expected Frequency More than twice a year Twice within three years Once every three years Once every five years
Average Loss to End of Decline Period 9% 18% 24% 30%
Chance of Continuing to next-level Decline 26% 48% 56%

Let's review the first data column in words so we fully understand. It says: a "Dip" is a decline greater than or equal to 5% (but less than 10%) from the previous Dow Jones Industrial Average high. Dips have occurred more than twice a year on average. A typical Dip produces a 9% decline before it's over. There's only a 26% chance [about 1 in 4] that a Dip will deepen into a "Moderate Correction".

We also learn that "Moderate Corrections" of 10% to 15% have occurred every 18 months, but that "Severe Corrections" of 15% to 20% only developed once every three years on average.

The last row of the table shows the "snowball effect" in downtrends: the deeper losses become, the more likely they'll continue to the next level of decline.

We shouldn't be sanguine about withstanding the psychological pressure of "Dips" or deeper declines because diversified portfolios will usually show bigger losses than the DJIA. If the bedrock Dow Jones Industrial stock prices drop 5% or 10%, the typical listed stock will fall far more! That leads us to consider...

What Makes A Market Decline So Painful?
Market Declines are always tougher to bear (no pun intended) than people expect. The bravado one hears during market advances ["I can accept a 20% decline"; "Bear markets are a buying opportunity"], quickly fades when prices drop day after day, week after week.

In general, markets drop faster than they rise. Investors begin to despair that so much value, built over many months or years of prudent attention, has evaporated so quickly. They start to doubt the validity of their investing methods and to lose confidence in their ability to make investment decisions. This self- flagellation is accentuated by incessant negative media reporting, relieved only by headline stories of the market genius who predicted the decline and "went to cash" the day before it began.

At first, it's the most speculative securities that fall like lead balloons. "Well," some will say, "people who bought those risky issues should have known better... they sowed, now they reap." But as a decline continues, "safer" and even "the safest" stocks are punished. There may be no reason other than spiraling fear and despair. People start to feel their lifetime goals slipping away from them... the comfortable retirement, the bigger residence for a growing family, the option to change their job or start a business, private school for the children ... dreams die. Nobody's "playing" the market anymore. Eventually, some investors become financially paralyzed; others capitulate and sell "at the bottom."

There's no sure way to sustain your equilibrium during a market decline. Diversification helps. Asset allocation helps. A stoic philosophy helps. Prior experience helps. But, in the end, coping with a  market decline is like surviving any other ordeal... a disease, a storm, an accident. You bring all your skills to the task and hope they'll be sufficient. Here are a few suggestions that might assist you when the next market decline befalls us...

Seven Ideas for Coping with A Market Decline
bulletIf your investment horizon is truly long-term, stop watching the markets so frequently. Evaluate your portfolio only biweekly or monthly. This "constructive disengagement" from the current moment's news and hype will help you keep a clear head.
bulletWhen valuing your portfolio, mentally "discount" both your gains and your losses by 20%. You know markets will fluctuate. By continually "discounting" your position, you prepare yourself for some give-back after a period of gains and some get-back after losses occur.
bulletMake a Buy List of securities you'd like to own and start your research on those companies while the Bear prowls. As the declining trend abates, you'll be ready to take advantage of the next Bull market phase.
bulletPsychologists tell us that investors take less pleasure from gains than they suffer pain from losses (of the same magnitude). Use that knowledge to temper your moods and set your asset allocation.
bulletLower markets are a good time to make gifts of appreciated assets... you can give away more shares without triggering gift tax and shift recovery gains to the recipients.
bulletUse a stock price drop to realize capital losses that will improve your portfolio and tax position. A declining market may highlight weaknesses in some holdings which lead to rational sell actions.
bulletLet go of the past. Don't punish yourself with "could have been" thinking. Markets always look ahead; you should too. You can take action today. You can plan to act tomorrow. But you can't act yesterday.

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