As investment professionals, we often ask clients, “How do you view risk?” But the more important question isn’t how you view it; it’s how you actually respond to risk when it becomes real. To explore this, here’s a quiz based on investor behavior during the 2008 bear market. For those of you newer to investing since 2008, just play along. But here’s the situation and questions to ask yourself: what would you have done if faced with the severe bear market coinciding with the Global Financial Crisis when the S&P 500 dropped over 50% in value from December 2007 through early March 2009?
1. Did You Stay Invested Throughout 2008?
If you did not sell stocks during 2008: Congratulations. You score at least 80% on this quiz. Proceed to question #2. Investors who stayed the course were able to fully participate in the recovery that began in early March of 2009.
If you made modest changes (reduced stock exposure by 10 to 15%): You score 65%. This reflects a reasonable adjustment without panic, but it also indicates that you were not fully prepared for a bear market.
This problem snuck up on many of us. We went through some good times in the market and forget that the good times don’t last forever. In fact, we may not have even realized how much the stocks in our accounts had grown relative to bonds or even considered the need to protect any of our gains.
Lesson learned: We need to plan for bear markets in advance. If you didn’t and had to adjust midway, at least you realized you needed a course correction and not a complete reversal. Unfortunately, there was a price to pay thus the deduction to your score, but if you ended up with the right risk allocation in the end, you were better prepared to ride out the rest of this bear market and are now ready for the next one.
If you made extreme changes or exited stocks entirely: Unfortunately, this results in a failing grade for the quiz. The challenge we faced during 2008 was not merely financial, but emotional. For many of us, it felt like the world (or at least the financial one) was about to end. We used phrases like:
“I need to protect what I have left.”
“I’ll invest again when it is safer.”
“I can’t sleep at night.”
These are all valid responses and feelings, but they can result in financial disaster. In order to be better off by getting “out of the market,” you would have to “get into the market” when it was even lower. Does that sound like a time when it is “safer”? Unfortunately, no. Many investors ended up in cash, treasuries or gold waiting for the “right time” when it would be safe to invest again. Once people felt comfortable, it was too late and the market had regained many, if not all of the losses. Just a reminder that the math of a full recovery from a 50% decline is a doubling of assets. So, if you got out at the bottom and waited for the recovery, you would end up with half as much money. Isn’t this the outcome you would be trying to avoid?
2. Did You Continue to Invest During the Downturn?
For those still accumulating assets (not retired), did you keep contributing to your 401(k) or other savings, even as the recession made this difficult for many? We had some investors say they were afraid of throwing good money after bad and chose to reduce or completely stop their retirement plan contributions after seeing large declines in their balances.
If you kept the pedal to the metal and kept contributing: Add 10% to your score. Staying invested and continuing contributions during downturns often leads to some of the best long term investment results, as you buy at market lows.
Extra Credit 5% Bonus: Did you increase your savings level during the market decline? This behavior demonstrates extraordinary patience and commitment. If buying low is a good thing, then buying more is even better, right? A great example would be making IRA or Roth IRA contributions early in 2009 at the very trough of the market rather than waiting for the year end or increasing your 401(k) or other retirement plan contributions.
3. Did You Rebalance Your Portfolio?
Did you actively rebalance in 2008? For example, if your target allocation was 60% stocks and 40% bonds, and stocks dropped sharply, did you sell bonds and buy stocks to restore your intended allocation? The stock market decline coinciding with a rise in high quality bond prices caused allocations to naturally change and become much more conservative.
If you rebalanced back to your intended allocation: Add 5% to your score. Rebalancing helps maintain your risk profile and can improve long term returns. Fortunately, high quality bonds led by treasuries rallied into the depths of the stock market decline. Investors who were able to reallocate from bonds to stocks during the depths of the downturn were not only able to buy stocks low, but they were also able to sell bonds high. This accelerated the recovery once it began.
Extra Credit 3% Bonus: Did you increase the level of risk in your portfolio? For those who were prepared for the bear market and had invested in safer bonds, they had the ability to not just rebalance, but even increase the allocation to stocks from bonds. The “right answer” tends to be to stick to your allocation, so we are only awarding 3% extra credit if you did this. But, if your financial plan allows the flexibility, we will give extra credit where credit is due.
4. Did You Use Tax Loss Harvesting?
For those with taxable accounts, did you take advantage of tax loss harvesting selling and replacing assets to realize capital losses, offset gains, and potentially deduct up to $3,000 against ordinary income?
If yes: Congratulations. Add 5% to your score. Tax loss harvesting can help reduce the pain of downturns by letting Uncle Sam share some of the loss. It’s often possible to replace existing investments that have declined in value with similar investments that can recover with the markets.
Investors often find it challenging to part with their investments at a loss, but remember when everything is down, this is a sell low, buy low proposition with a tax benefit.
For those with only IRA and retirement accounts, we provided an extra credit opportunity for you.
5. Extra Credit: Did You Make a Roth Conversion?
As extra credit, if you had an IRA and your account balance was down, did you convert to a Roth IRA, paying taxes on the lower balance and allowing future recovery to be tax free?
If yes: Add 5% more to your score. This advanced planning technique can be highly beneficial by allowing you to pay taxes on the balance of the conversion today, but allow the future growth including the recovery to be untaxed. While there were income limitations in 2008 and 2009, those were lifted in 2010 which was still in the early part of the recovery period.
Key Takeaways: How can you score 100% in the next bear market?
The most important action in a downturn is to stay invested. Bear markets are inevitable, and preparation is crucial.
Proper allocation and readiness allow you to stay the course, continue investing, rebalance as needed, and take advantage of opportunities like tax loss harvesting and Roth conversions.
For retirees taking distributions, maintain a balanced portfolio and withdraw proportionally from appreciated assets.
Don’t shy away from investing during downturns. These can be the best opportunities. Extra credit if you increased contributions or risk during tough times.
Disclosure
This content is for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product or services nor tax or legal advice. This content is provided solely for your personal use and shall not be deemed to provide access to any particular transaction or investment opportunity. Quotient Wealth Partners, LLC does not intend this information to be investment advice, and the information presented should not be relied upon to make an investment decision. Any third party information contained herein was prepared by sources deemed to be reliable but is not guaranteed. Quotient Wealth Partners, LLC, is not affiliated to any specific companies mentioned.
