The S&P 500, which represents about 80% of the value of the U.S. stock market and is tracked by the C Fund, had its first positive week in a while last week, including one of the best-ever days in stock market history.
It began with the first solid “bounce” of this bear market, after a sharp sell-off that went straight down week after week, without two consecutive up days in a while:
Most bear markets take months to play out. It remains to be seen if this was “the bottom” on the way towards a strong rebound, or just “a bottom” on the way to a deeper low.
What is unintuitive to most investors is the fact that the market’s biggest positive days tend to be clustered in bear markets.
During bull markets, volatility tends to be low, so the market pushes up day after day, with a fraction of a percent each day. However, the market’s biggest up days, where broad stock indices gain 3%, 5%, 10% or more, tend to occur in major market crash years like 2020, 2008, and 1929. In other words, the worst days and the best days for the stock market tend to be clustered together in a period of high volatility.
If we look at the 2008 bear market, for example, there were plenty of sharp bear market rallies:
Invest with Reason, not Emotion
Above all, the key thing for investors to avoid is the pattern of constantly buying high and selling low, with emotion.
Research from J.P. Morgan, Dalbar Inc, and other firms has shown that retail investors tend to underperform all asset classes, because they frequently buy high and sell low:
In other words, they buy stocks when stocks are doing great, and then after a big crash, they get scared and buy bonds or go to cash instead, and thus miss out on the recovery after experiencing the full decline.
Then after the recovery happens and stocks become expensive again, it feels safe and they start buying stocks again, repeating the cycle anew.
Many of the world’s best investors, including Warren Buffett, use a counter-cyclical approach, meaning they buy more bonds during overvalued stock periods, and buy more stocks when stocks are cheap after a crash. But that involves a large degree of watching the stock market, measuring valuations, mapping the business cycle, managing emotions, avoiding conflicts of interest, and so forth.
The next best thing, and far easier, is to maintain a diversified portfolio that you rebalance on occasion. In other words, if you don’t want to try the difficult task of timing the market, at least don’t emotionally negative-time it by buying high and selling low during each business cycle.
From the beginning of the year, treasuries and gold have been major out-performers, while domestic and foreign stocks have been down. Oil has been hurt even more:
Back in late January before this crash occurred, I warned about COVID-19 and the importance of diversification and maintaining a strong personal financing position in my article: TSP: The Market Pulls Back on Virus Headlines: “In the meantime, an overbought market is ripe for potential correction, and is why diversification is so important. When volatility is low and equity valuations are high, it only takes a small disruption to trigger a selling event.”
Now that it has occurred with even more severity than expected, diversification into bonds in the TSP, or other defensive asset classes like gold outside of the TSP, have played their role.
Stocks are cheaper than they were before the crash, but may go lower. The key is to stick with an investment plan, and to maintain a portfolio that is risk-appropriate for your age and unique financial situation. Rather than move capital around based on emotion, move it or don’t move it based on a sound financial plan. Don’t buy high and sell low; buy and diversify appropriately with a plan in all market conditions.