How to manage risk in a bear market

What are the characteristics of a bear market, how can you protect yourself, and what should you do now? Stress-test your portfolio with our bear market calculator.

Introduction

When it comes to understanding market risks and their impact on investment success, there is an elephant in the room—or rather, a bear. Bear markets occur when there is a greater-than-20% peak-to-trough drop in the S&P 500. Although the 20% threshold is arbitrary, crossing this level has historically been an important dividing line between painful-but-short-lived corrections—where recovery time is measured in months—and the years-long recovery period for bear markets. In 2020, we saw an exception to this rule of thumb, with a bear market that set multiple records: 

  • The fastest peak-to-trough drawdown. The S&P 500 fell from its bull market peak to its bear market peak (on a monthly closing basis) in three months; this is a tie with the 1987 bear market for the fastest bear market drawdown. 
  • The fastest recovery time. It took just four months for the S&P 500 to rally from its market trough to a new all-time high. 
  • The fastest time to full recovery. The whole bear market—from peak to new all-time high—lasted just seven months, versus a previous record of 16 months. 

Because of its speed, this bear market caused far less lasting damage to investor portfolios than a usual bear market. In fact, the exceptional 2020 market recovery helps to underscore the fact that the size of a market drawdown is far less important than its duration. That being said, even deeper and longer-lasting bear markets aren't as dangerous as they seem. Our Bear market guidebook cuts through misconceptions and provides you with the tools you need to protect yourself against market downturns. In three parts below, we discuss the characteristics of a bear market; explain why bear markets need not threaten financial success; and provide insight into how they can be an opportunity to improve long-term returns for those who are prepared.

What is a bear market?

A period in which US stocks fall by more than 20% from a peak. But most bear market damage occurs while markets struggle to recover from this drop.

Part 1: Recognize a bear market

How painful are they, and how long do they last?

Part 2: Protect against a downturn

How can you prepare your portfolio and plan?

Part 3: Open in case of emergency

What steps can you take once in a bear market?

 

Stress-test your portfolio

Although bear markets are painful, it usually only takes a few years for the stock market—and even less time for balanced, diversified portfolios—to fully recoup bear market losses. Even in a worst-case “super bear market,” market losses are temporary for investors who are able to stay the course.

The main risk that investors face during a bear market is panic, but even the most patient investors can be forced to sell at bear market prices if they are living off of their portfolios. When an investor sells part of their invested portfolio during a market drawdown, they not only lock in otherwise-temporary losses—they also prevent their assets from fully participating in the market recovery and future gains. For unprepared investors, an ill-timed bear market can force them to catastrophically deplete investment portfolios. This dynamic is a particularly potent danger for retirees without a well-funded Liquidity strategy—cash and short-term bonds to maintain their lifestyle.

Our “Bear market calculator” helps you to estimate the cost of selling during a bear market—what we call “bear market damage”—by running your portfolio and your plan through a super bear market. While we don’t expect the current bear market to be anything like this worst-case scenario, the exercise provides useful perspective about the difference between pain (temporary “paper” losses) and damage (locking in losses and forgoing gains). The calculator works in three stages:

Stage 1

First, the calculator takes your investment portfolio and runs it through a super bear market comprised of the most dangerous elements of all of its previous post-WWII bear markets. For example, take a $1,000,000 portfolio invested in a 100% stock portfolio. The portfolio suffers its worst-ever drawdown, falling 51% to $490,513 at its trough, and takes 74 months (April 2026, assuming a February 2020 starting day) to fully recover and set a new all-time high.

Stage 2

Next, the calculator applies your planned withdrawals or deposits to evaluate how they affect the portfolio’s drawdown and recovery dynamics. The result is an exaggeration—a worst-case scenario—that can help you prepare and test strategies that might reduce risk. For example, after a $1,000/month withdrawal during the bear market, which deepens the portfolio’s trough value to $467,179. By the time the portfolio would have fully recovered without withdrawals (April 2026), the portfolio only has $881,496 left. This $118,504 shortfall from its starting value is due to $73,000 of withdrawals and $45,504 from bear market damage.

Stage 3

Finally, if you are planning to spend from your portfolio, the calculator allows you to re-run the simulation assuming you began with a fully funded Liquidity strategy to act as an alternative source of funds during the bear market—effectively insulating you from bear market damage. For example, with a Liquidity strategy to accommodate spending needs, the portfolio suffers no bear market damage, and ends the simulation with $927,000—the starting portfolio value minus the $73,000 of withdrawals.

Growth of $100 invested during past bear markets

100% US large-cap stocks, from bull market peak to full recovery

Source: MorningstarDirect, UBS, as of 7 April 2020

Bear market calculator

An illustrative portfolio stress test for market downturn preparedness

Enter your portfolio’s value in February 2020.

This is when the bull market peaked and the current bear market began.

What is the peak date based on?

The bull market peak is based on the S&P 500 index’s last all-time high, set on 19 February 2020. Subsequently, the S&P 500 has dropped by more than 20%, officially entering a bear market when it crossed this threshold on 12 March 2020.

In our definition, a bear market does not end until the S&P 500 registers a new all-time high. In this context, bear markets have two parts: the drawdown (from peak to trough) and the recovery (from trough to new all-time high). This “time under water” period is when you may be at risk of locking in otherwise-temporary losses and incurring what we refer to as “bear market damage.”

Select your portfolio’s stock/bond allocation at the peak.

Pick the mix closest to your risk level at the start of the bear market.

How might your portfolio look under the worst historical circumstances?

Without adding to or taking from your portfolio, the value at the trough would be . Your portfolio would fully recover to its value in .

What do we mean by “worst historical circumstances”?

Every bear market is different, but each features three components that create risk for you as an investor: maximum drawdown, time under water, and recovery time. To stress-test your plans and portfolios, this calculator simulates a “super bear market.”

The super bear market comprises three sections: the largest drawdown the portfolio has seen in past post-war bear markets, occurring over its fastest peak-to-trough period; a “plateau” period during which the portfolio stays at its trough value; and a recovery period, where the portfolio endures a very slow-but-steady rally from the trough back to a new all-time high.

Do you plan to save or spend during the bear market?

Between and , will you make deposits into or take withdrawals from your portfolio?

I'll make deposits
I'll take withdrawals
I'll do nothing

How much per month?

Estimate the average monthly amount in this timeframe.

How might your deposits change your portfolio under the worst historical circumstances?

Your portfolio’s trough value would increase to , more than the if you weren’t adding to your portfolio. In , you would have , more than the without deposits. of this is due to your deposits; the remaining is from growth of your deposits during the bear market recovery.

“Risk” can be “reward”

Investors in their “accumulation phase” gain the largest benefit from the riskiest portfolios, since these portfolios’ “worst case” characteristics (fast and large drawdowns, extended “plateau” period, and a long and slow recovery period) work in their favor. So while all-equity portfolios are generally not the optimal way to maximize wealth accumulation—owning some bonds enhances risk-adjusted returns and gives additional rebalancing opportunities—they may be appropriate for investors who are contributing a sizable chunk to their portfolios and have an emergency fund to manage potential sequence risk.

Contact your advisor today

Congratulations, it appears that you are already protecting your spending needs from volatility and even adding to your portfolio at discounted bear market prices. For more ways to take advantage of market drawdowns, and to make sure you’re on track to meet your long-term goals, discuss the Liquidity. Longevity. Legacy. (3L) framework with your advisor today.

Start a conversation

Restart the simulation

The value of investments may fall as well as rise and you may not get back the amount originally invested.

Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.

How might your withdrawals change your portfolio under the worst historical circumstances?

Your portfolio’s trough value would decrease to , lower than the if you didn’t withdraw from the portfolio. In , you would have , which is less than the recovery value without withdrawals. of this is due to your withdrawals throughout the bear market; the remaining represents what we call “bear market damage”.

What do we mean by “bear market damage”?

When an investor is forced to sell out of their portfolio during a market drawdown, they not only lock in otherwise-temporary losses, but they also prevent their assets from fully participating in the market recovery and future gains.

To quantify this damage, we first find the difference between your portfolio’s ending and starting values, and then either add back spending or subtract withdrawals to adjust. What remains is considered “bear market damage.” For example, if you start with $100, spend $50, and end with $40, then the bear market damage is $10 ($100 - $40 - $50 = $10).

How can you avoid this?

Using our Liquidity. Longevity. Legacy. (3L) framework, you can build out a Liquidity strategy that allows you to fund your spending needs without locking in otherwise-temporary losses. Let’s take a look at what would happen to your portfolio using a fully funded Liquidity strategy.

Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.

How would leaving your portfolio alone affect it under the worst historical circumstances?

Your portfolio’s trough value would remain at . When the market fully recovers in , your portfolio would also fully recover to . Bear markets are painful, but when you don’t spend out of your portfolio during one, you don’t lock in any otherwise-temporary losses. As a result, you don’t incur any bear market damage.

What do we mean by “bear market damage”?

When investors are forced to sell out of their portfolios during a market drawdown, they not only lock in otherwise-temporary losses, but they also prevent their assets from fully participating in the market recovery and future gains.

To quantify this damage, we first find the difference between your portfolio’s ending and starting values, and then either add back spending or subtract withdrawals to adjust. What remains is considered “bear market damage.” For example, if you start with $100, spend $50, and end with $40, then the bear market damage is $10 ($100 - $40 - $50 = $10).

Contact your advisor today

Congratulations, it appears that you are already protecting your spending needs from volatility. If you would like to find ways to take advantage of market drawdowns, or if you would like to make sure you’re on track to meet your long-term goals, discuss the Liquidity. Longevity. Legacy. (3L) framework with your advisor today.

Start a conversation

Restart the simulation

The value of investments may fall as well as rise and you may not get back the amount originally invested.

Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.

How would protecting your spending needs change your portfolio under the worst historical circumstances?

Your portfolio’s trough value would increase to , higher than the without using the 3L framework. In , you would have , which is more than the without using the 3L framework. By building a Liquidity strategy ahead of time, you would be able to fund your of withdrawals while incurring bear market damage of versus without using the 3L framework.

What else can you do to reduce bear market damage?

If you can afford to reduce spending or deploy excess cash during bear markets, it is possible for you to dramatically reduce bear market damage. Before you do this, make sure that you have enough resources to get you through the full bear market period without having to compromise on maintaining your family’s lifestyle. This is the key to limiting bear market damage, and it’s something you should review and discuss in depth with your advisor.

Contact your advisor today

To learn more about how the 3L framework can help you maintain your lifestyle during periods of volatility while also remaining keenly focused on growing wealth for your long-term objectives, discuss this—and other ways to prepare your portfolio for bear markets—with your advisor today.

Start a conversation

Restart the simulation

The value of investments may fall as well as rise and you may not get back the amount originally invested.

Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.

 

Bear market characteristics

We define a bear market as an episode where US large-cap stocks fall by at least 20% from peak to trough. But rather than focus only on the peak-to-trough drop time period, or the drawdown period, we also stress the importance of considering how long it takes for stocks to register another all-time high. After all, the time under water—when markets are struggling to recover from their losses—represents the period in which you may be forced to lock in losses.

A big percentage change for one asset class may represent a relatively minor move for another. So while we use US large-cap stocks as the basis for defining bear markets, this is only for clarity. Well-diversified portfolios—which include global stocks as well as fixed income—are structurally designed to protect against the most painful parts of equity bear markets.

With this in mind, let’s look at US large-cap stock statistics for equity bear markets since World War II in order to evaluate what market cycles look like using our framework.

Peak year

Peak year

1946

1946

1961

1961

1968

1968

1972

1972

1987

1987

2000

2000

2007

2007

Average

Average

Peak year

Length of prior bull market*

1946

169

1961

184

1968

78

1972

31

1987

157

2000

155

2007

62

Average

119

Peak year

Time between market cycles**

1946

204

1961

190

1968

84

1972

50

1987

179

2000

158

2007

87

Average

136

Peak year

Peak

1946

31/05/1946

1961

31/12/1961

1968

30/11/1968

1972

31/12/1972

1987

31/08/1987

2000

31/08/2000

2007

31/10/2007

Average

 

Peak year

Trough

1946

30/11/1946

1961

30/06/1962

1968

30/06/1970

1972

30/09/1974

1987

30/11/1987

2000

30/09/2002

2007

28/02/2009

Average

 

Peak year

Recovery date

1946

31/10/1949

1961

30/04/1963

1968

31/03/1971

1972

30/06/1976

1987

31/05/1989

2000

31/10/2006

2007

31/03/2012

Average

 

Peak year

Max drawdown

1946

–21.8%

1961

–22.3%

1968

–29.4%

1972

–42.6%

1987

–29.6%

2000

–44.7%

2007

–51.0%

Average

–34.5%

Peak year

Time to full recovery (new all-time high)

1946

41

1961

16

1968

28

1972

42

1987

21

2000

74

2007

53

Average

39

Peak year

Drawdown time

1946

6

1961

6

1968

19

1972

21

1987

3

2000

25

2007

16

Average

14

Peak year

Recovery time

1946

35

1961

10

1968

9

1972

21

1987

18

2000

49

2007

37

Average

26

Peak year

Months of prior gains 'erased'

1946

15

1961

36

1968

66

1972

118

1987

18

2000

64

2007

141

Average

65

When assessing bear market risk, it’s important to cut through the taboo that surrounds them. Yes, bear markets are painful. But they are also rare, and over relatively quickly. Since 1945, stocks have spent about two-thirds of the time at or within 10% of an all-time high. In this light, it’s clear that markets behave more like a runaway train than a cycle or clock when viewed over the long term. As an investor, your job is to try to keep up with the train, which rarely stops and never truly goes backwards. This context is noteworthy as you ask yourself how much long-term growth you’re willing to forfeit in order to improve your comfort level during the painful-but-rare pauses.


 

How to prepare for a bear market

Unfortunately, history tells us that the quest for the perfect hedge may be a wild goose chase. No matter how well-intended or designed, the strategies that provide the most potent protection against equity downside risk also tend to be the most costly as they sacrifice long-term growth potential.

We typically recommend prioritizing cost-effective protection before moving on to less-reliable or costlier hedging strategies. Below are four “damage mitigation” strategies, in declining order of efficiency.

1. Think structurally

Make sure that your portfolio is taking the right amount of risk in order to meet your short- and long-term objectives. If those objectives appear in conflict, the Liquidity. Longevity. Legacy.* (3L) framework may help ensure that your portfolio can meet both sets of goals.

The 3L framework starts with the Liquidity strategy, which is designed to provide needed cash flow over the next 2-5 years, securing your ability to hold risk assets during a downturn.

The Longevity strategy is constructed to include all assets and resources needed for the rest of your life, clarifying what your future spending objectives will likely cost.

The Legacy strategy comprises assets in excess of what you require to meet your own lifetime objectives, clarifying how much your family can do to improve the lives of others now or in the future.

2. Plan strategically

The most direct way you can manage equity risk is to trim some stocks from your portfolio in favor of a higher allocation to government and municipal bonds. With that said, large changes in your portfolio’s allocation should only be made rarely and proactively.

By contrast, we don’t recommend jumping into or out of the market based on short-term forecasts—emotions tend to trump reason once markets become volatile.

We believe it is particularly important to hold well-diversified portfolios during late-cycle environments. Although somewhat-concentrated portfolios can work very well during bull markets, less-diversified portfolios are fragile, exhibiting larger drawdowns and longer recovery times in bear markets.

3. Consider hedges

Many strategies could mitigate your portfolio’s downside exposure if used to replace part of your equity allocation. You can also consider a systematic allocation strategy, hedge funds, or structured notes that accept limited upside in return for explicit downside protection.

In general, we prefer hedging positions that provide meaningful downside protection during a bear market, but don’t cost too much if the bull market continues. These include long-duration bonds, regime-shifting strategies that can cut equity positioning substantially, and certain structured products that cap downside exposure.

As a general rule of thumb, the more perfect a hedge is, the more costly it becomes. If you find something that seems to be an exception to this guideline, tread carefully—it may be too good to be true.

It’s important to remember that downside protection is less important for meeting long-term goals than it seems. Don’t sacrifice too much upside to protect against temporary losses.

4. Manage liabilities prudently

If used carefully, debt may greatly benefit bear market returns. The capacity to borrow can help you avoid selling at bear market prices and can vastly amplify return potential in the first stages of a recovery period. But, if used imprudently, debt can be ruinous.

Debt can be segmented into two categories: strategic debt— generally longterm and helpful for maintaining diversification and flexibility on a balance sheet—and tactical debt—used opportunistically on a short-term basis to improve outcomes. Make sure you manage both carefully to avoid being caught off-guard by a market decline or unexpected liquidity need.

A note of caution: Borrowing costs have increased commensurately with interest rates. Investors should have a plan to pay down debt when markets are healthy. This, along with consolidating assets to increase availability and improve borrowing terms, can help make sure that borrowing capacity is available during bear markets.


 

What to do during a bear market

There are a handful of tactics you can employ during a bear market:

Don’t panic

Remember that bear markets are painful but temporary. If you are already in a well-diversified portfolio, your bear market experience will be very different from that of the S&P 500. Sticking to your plan is key, so resist the urge to change the risk profile of your portfolio or make sizable shifts out of stocks or into cash.

Portfolio management

Use sell-offs as opportunities to harvest capital losses—a strategy that we estimate can add about 0.5% to after-tax annual portfolio returns over the long run. Also rebalance your portfolio so that it doesn’t drift from your target allocation; in addition to reducing portfolio risk, this can also enhance upside capture.

Play for time

Look for ways to increase your savings rate or cut back on spending. This is also a time to consider tapping borrowing facilities as a bridge to avoid locking in losses, but don’t take on too much leverage in case markets don’t quickly recover.

Tactical opportunities

While every bear market is different than the last, there is one constant: There are always market dislocations that can provide opportunities to enhance returns. Generally, we recommend leaning in to risk assets when market prices are out of step with fundamentals, and there are some strategies that can take advantage of market pessimism to enhance returns in a rebound. If you enter a bear market well prepared, you may be able to unwind portfolio hedges and temporarily increase portfolio risk to take advantage of higher return potential. Talk with your financial advisor about which strategies make the most sense for you.

Read the full report

For a deeper read, download the full whitepaper, Bear market guidebook: How to manage risk and harness opportunity in a market downturn.


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