Bear markets for the young

CIO Global Blog

20 Aug 2019

"Youth is the best time to be rich, and the best time to be poor," according to Euripides. This quote resonates with me, especially as I think about bear markets for people who are in their working years.

When I received my first paycheck in the fall of 2007, the Global Financial Crisis was just starting. I was living in Hong Kong, with no investment assets and very little income. Within just a few weeks of working there, shares in the bank where I was working fell 10%. Following my coworkers' advice that this was a buying opportunity, I bought some shares...which proceeded to fall another 94% in value by the trough of the bear market in March 2009.

It felt like an expensive mistake at the time, but the truth is that I was fortunate to learn these lessons early: don't overinvest in one stock; diversify beyond the industry where you're building a career; and capital losses aren't worth much when you're still in a low tax bracket.

On the one hand, I was lucky that the Global Financial Crisis occurred when it did. It happened early enough that I suffered almost no market losses from the bear market drawdown, and I was fortunate to stay employed throughout the recession, so I was able to put some money to work during the "bear market window."

On the other hand, my savings rate was pretty low because I was still building up an emergency spending buffer and my starting salary wasn't much higher than my cost of living. If the bear market had started a few years later, I would have suffered more "paper losses" in my investment account, but I could have contributed significantly more near the trough of the market.

What is the opposite of damage?

As we discuss in our Bear Market Damage Index (BMDI) report, bear markets cause harm if an investor is forced to sell out of their invested assets in order to pay their bills. This is why, generally speaking, bear markets pose a greater risk to investors in retirement or near enough that they will begin withdrawing from their accounts during the next "bear market window." Retirees can mitigate this damage by cutting spending and by having a Liquidity* strategy to help create a buffer between market volatility and their cash flow needs.

If we use the same calculation for young investors, but use a negative "spending rate" to reflect that funds are being added to the portfolio, the math works out very differently, highlighting a very simple but counterintuitive fact: bear markets during your working career are good for your financial plan.

To recap our BMDI methodology, we run a simulation of the portfolio's value, after cash flows, up until the end of the longest-ever bear market window. At this point, the portfolio would have recovered back to a new all-time high without spending. The BMDI reflects the percentage of the portfolio's depletion, indexed to 100. However, when there are additions, there is no depletion; in fact, the portfolio has more capital at the end than at the beginning of the simulation, so the BMDI is negative.

In the example below, we assume that the investor contributes 4% of the portfolio starting value (e.g. a –4% spending rate), increased by 2% p.a. to reflect a constant "real" dollar amount. Because the investor is in their working years, their Liquidity strategy is limited to an emergency fund (12 months of spending, to account for a potential job loss or unknown expense), so they don't experience a cash drag on their portfolio performance.

This USD 1 million all-equity portfolio would have experienced a 51% drawdown over the course of three months, and spent about 22 months at the plateau, before beginning the 49-month climb back to a new all-time high, resulting in a "bear market window" (time from peak to peak) of 74 months.

At a 4% initial contribution (USD 3,333 per month), rising at 2% p.a., an investor would have added about USD 258,383 to the portfolio during this window (USD 81,538 by the end of the "plateau" and another USD 176,845 during the trough-to-peak recovery period). With a portfolio value of USD 1,416,489 at the end of the "bear market window," the BMDI for this portfolio is –42 (USD 1,000,000 starting value, minus the USD 1,416,489 ending value, divided by the USD 1,000,000 starting value, multiplied by 100). Another way of putting it is that portfolio experienced about USD 158,106 of "negative damage," because this is how much extra it gained due to the bear market (USD 1,416,489 ending portfolio value minus USD 1,258,383 total contributions).

For the young, "risk" can be "reward"

Investors in their "accumulation phase" gain the largest benefit (most negative BMDI) 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 allequity 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.

*Liquidity. Longevity. Legacy. disclaimer: 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.

Figure 1 - A "super bear market" with portfolio contributions

Growth of USD 1,000,000 with monthly contributions of 4% p.a.

100% stock, 0% bond portfolio

Source: UBS, MorningstarDirect

Figure 2 - BMDI statistics with contributions

"Super bear market" statistics, BMDI values for portfolios with a 4% p.a. contribution

Source: UBS, MorningstarDirect

Author:

Justin Waring, Investment Strategist Americas, UBS Financial Services Inc. (UBS FS)

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