Surviving and Investing in a Bear Market

Deep breath in through the nose and out through the mouth.

And again. In through the nose and out through the mouth. Feel better? Alright, well it was worth a shot. 

It has been a rough start to the year with the S&P 500 off almost 9% through the 25th of January. And, that's the tip of the iceberg. Other parts of the market are deep in the red – unprofitable tech stocks, represented by Cathie Wood’s ARKK ETF, are down 27%. You can call it a sell-off, bear market, reckoning, speed bump. Whatever. It hurts. 

When I was a newly minted investment analyst at a large mutual fund and ETF provider, fresh off getting my CFA designation, I went on a client visit to see a regional bank. The Chief Investment Officer at the bank seemed annoyed that his counterpart in the meeting still had spots. While debating the merits of laddered bond portfolios vs. bond mutual funds, the CIO stopped the conversation and asked pointedly, “how old are you?”. 

A few snarky responses flashed across my brain before I answered, “26.”

“Well,” he retorted, “you haven’t worked through a bear market. You don’t understand.” 

For some, weathering a bear market is a rite of passage. You are not a captain until you’ve sailed safely through that first storm.

However, bear markets can be scary no matter how many you have been through. That’s because money is emotional and portfolio fluctuations can have real life consequences. Maybe you have a kid on the way and you’re worried about their future or maybe you are looking to retire and you may have to work longer. These are real concerns and fears that we have to confront when looking at all that red on the screen. 

And don’t get me started on those people who say, it's just “paper losses”. They are the worst.

That said, these downturns are a normal part of investing. Since 1942, there have been 14 bear markets. Some only lasted a month while others hung around for over a year and a half. Each bear market is unique and difficult to predict or time. However, I think it’s safe to assume that there will always be a next one. And, I would argue surviving a bear market makes us better investors, just like playing against better competition makes us better athletes. With each cycle, we are better prepared, less likely to tinker, and more likely to shrug it off. 

Whether this will be your first bear market or you’ve seen a few, here are a few tips from Composer that could help you. ‍

Branch out: diversify your portfolio

A diversified portfolio can reduce volatility and drawdowns during downturns. Diversify by holding broad-based index funds, multiple asset classes, and investing in regions across the world. Unfortunately, during periods of instability assets may move together (i.e., increased correlations) which reduces the benefits of diversification, so adding alternatives and hedge fund-like strategies to traditional asset classes can provide additional benefits.

Through Composer, it is easy to add new asset classes to a symphony [1] and test their impact on returns, max drawdown, volatility, and Sharpe ratio. You can narrow backtest results to see how symphonies would have performed in previous bear markets like the Global Financial Crisis in ‘08/’09 or the 2020 COVID crash.

Further, you can create hedge fund-like strategies by combining exchange-traded funds (ETFs) with trading logic - specify assets, weights, conditions, filters and groups. Harness the power of systematic investing to build and test unique strategies, adding diversification to your portfolio.  

Be disciplined

As Jason Zweig, columnist for the Wall Street Journal puts it, “when you drastically change your long-term course based on what feels like a short-term sure thing, you’re likely to end up caught by surprise—and racked with regret.” Panic selling is the siren singing on the island, distracting you from your noble quest. As we’ve talked about before in our blog, discipline is key to successful investing. 

Composer builds discipline directly into your portfolio. Investors determine the assets, trading rules, rebalance frequency, and weights for their strategy. The symphony automatically trades based on those criteria, helping investors stay on course and avoid emotional decisions. And, if you need a bit more reassurance, review those backtests to see how the symphony has weathered bear markets in the past.

Remember, these emotions are pulling you away from your long-term plan and leading you to an unproductive place where you are trying to time the market. Which reminds me…

‍Don’t try to time the market

Trying to catch the market at the bottom is a fool's game. Short-term market movements are a random walk, meaning there is no way to predict which direction or at what magnitude they will move. After the S&P 500 returned ~31% in 2019 and ~18% in 2020, how many people said, “time to get out and harvest those gains. No way we can have another year like that.” Instead, the S&P went up ~29% in 2021. 

Research firm Dalbar has tracked investor performance for over 27 years, and according to their website, “the results consistently show that the average investor earns less – in many cases, much less – than mutual fund performance reports would suggest.” Said differently, the average investor is a poor market timer. And looking at their 2021 mid-year update, we see that investors fell behind the market by over 2% as they divested from equity markets in 2020 and into 2021.

Another famous example of poor market timing comes from one of the greatest investors of all time. Peter Lynch managed the Fidelity Magellan Fund from 1977 to 1990 and over that period the fund returned a metoric 29% annual return. Ironically, the average investor in the Magallan fund earned only a 7% annual return due to terrible market timing. Investors bought into the fund after strong performance and cashed out after periods of underperformance.  

Friends don’t let friends time the market.

‍Avoid doom scrolling  

Perhaps I spend too much time on twitter (shameless plug: follow me @kyle_composer), but I am always shocked at how media outlets and pundits frame the stock market. I understand that negative headlines get more clicks, but geeze. As someone trying to stay informed, I’m inundated with headlines from financial influencers, WSJ, FT, and Bloomberg about our impending doom. Oh, it's the biggest drop in the market since some obscure date? Good to know. 

Sitting here on Wednesday January 25th shortly after noon, the first two headlines on Bloomberg and WSJ read “Stocks Slump Anew as Fed, Russia Stoke Volatility” and “Stocks Drop as Market Turbulence Continues”. These types of headlines can be overwhelming and make you feel like you should do something with this information. 

To cope, I like to read opinions from investors who help put these moments in historical perspective and preach to stay the course. Or, I step away from FinTwit and Bloomberg Surveillance for a few days to clear my head. I also find it helpful to have a trusted support group. Here at Composer HQ our #investment-strategy slack channel is a safe place to share symphonies and musings on the markets. Sometimes, a little empathy and a friendly reminder to stay the course are just what's needed. ‍

Investing strategies for a bear market

The best time to prepare for a bear market is before it happens. If you’re concerned about your portfolio, some of the strategies below may be worth evaluating to complement your existing investments. 

Below, we look at three types of strategies: defensive, risk parity, and long volatility. We compare returns to the S&P 500 for YTD (through Jan 25th) and over the past 3 years, which includes the COVID crash and resulting recovery. Each strategy has a different risk and return profile to offer investors.

Defensive strategies

These strategies favor low volatility stocks, short-duration bonds, yield, and quality because these assets and factors tend to do better than the broad market during downturns. Here is a low volatility risk parity symphony that can provide downside protection while delivering returns in excess of the bond market; however, these strategies are likely to lag in bull markets and may best complement riskier or equity-heavy portfolios.

Risk parity

These strategies popularized by Ray Dalio and Bridgewater seek to deliver consistent returns by balancing the risk of a diversified set of assets. Their goal is to perform well in bear and bull markets. Here is an example symphony adapted from Artemis Capital’s Dragon Portfolio. 

Long Volatility

These strategies can deliver positive returns when volatility spikes and markets crash. Check out the blog post last week on investing in ETFs that mimic long volatility assets. You can find our Long Vol symphony here.

In the graph below, Low Volatility is blue, Dragon Portfolio is green, Long Vol is yellow, and S&P 500 is pink.

YTD returns through January 25th, 2022

Starting with the YTD chart, we see all three symphonies, while negative, have held up better than SPY (representing the S&P 500). The Low Volatility symphony has been the best performer which makes sense given its larger allocation to bonds, TIPs, and gold. The Dragon symphony and Long Volatility symphony both employ dynamic asset allocations that shift away from equities towards other asset classes as market uncertainty increases. The goal of these strategies is to capture upside while reducing downside risk. Here the strategies are performing as expected with smaller drawdowns than SPY.

3 year return statistics (January 24th 2019 - January 25th 2022)

Over the 3 year period, we see that the Low Volatility symphony lags SPY, but delivers strong risk adjusted returns with a 1.38 Sharpe ratio. The Long Vol and Dragon portfolios have performed well over this period and their tactical asset allocation shifts have been able to reduce drawdowns while still capturing the upside of equity returns over this period.

‍Bear down

‍Composer can incorporate dynamic defensive, risk parity, and long vol symphonies into your portfolio. And, the automated trading lets you sit back and watch your plan get executed, keeping emotions in check. I don’t know when the next bear market will happen, but I can guarantee it will. The best strategy is to be prepared. Visit composer.trade to get started investing in strategies that could help you through the next cycle.