Not a question of how much, but how long Prepare portfolio for a drawn-out bear market

My sister came across an old press clipping of mine when she was cleaning out the basement. It was an interview with William Hanley. Longtime Financial Post readers will remember the Lunch Money column where Bill waxed on eloquently about the food at fine restaurants while people like me provided a few morsels of business wisdom.

The yellowed piece of paper was from February 2003, which was almost three years into the tech wreck. I was president of PH&N at the time, and it sounded like I was in desperate need of a free lunch. At one point I said, “Everybody has unhappy clients. Our equity portfolios are down a lot and our balanced fund has struggled … We’re testing their patience a little bit right now.”

HOW MUCH FOR HOW LONG

Today, there’s much talk about the potential for a market correction. Stock prices have been going up for nine years. The few pullbacks we’ve had were followed by quick, decisive recoveries. The most recent, ending in February 2016, saw stock indexes down 1015 per cent, but new highs were being hit by summer.

The Lunch Money article spoke to something quite different — a down market that stayed down.

Today, my biggest concern is the duration of the next pullback, not the magnitude. A 15 per cent to 20 per cent decline wouldn’t be fun, but most investors would stay the course. If stocks didn’t recover for 2-3 years, however, investor behaviour could be quite different. Even experienced investors will get worn down.

IT CAN’T HAPPEN ... CAN IT?

I wasn’t in the business in the mid-1970s, but I’m told that those years were a real grind. My brother, who was a successful stock broker at the time, got so worried about putting food on his family’s table that he left the industry. He wasn’t alone.

Unfortunately, experience and memories are short. From what I’m hearing, most investors are expecting another V pattern — “We’re due for a correction but I can’t imagine the market staying down for long. It always bounces back.”

Well maybe, but the most likely bookend to a long, strong cycle is an extended consolidation, not a V. Super cycles aren’t followed by soft landings. Look at the hangover that followed the late 1990s tech boom. The normalization of valuations kept markets below their highs for six years. The tech-heavy Nasdaq Index didn’t register a new high until 2015.

Similarly, Toronto housing prices took more than a decade to climb back to their 1989 peak. Gold is well below its 2011 high of $1,900. And the aftermath of the most recent commodity and energy boom has been painful and prolonged.

Economic recessions and bear markets are inevitable because prosperity and profits bring more competition, a surge in investment, and ultimately reckless behaviour. Fortunately, downs tend to be much shorter than ups.

WHAT TO DO?

I’ll have more to say when the grinding starts, but in the meantime, here’s a preview.

First, plan for your portfolio to not come back right away. If you’re younger and building a nest egg, these preparations are mostly mental. You need to make a commitment to hanging in when the going gets tough. There’s not much else to do.

If, on the other hand, you’re decumulating, then cash flow planning and budgeting is also in order. Kitchen renovations, trips abroad and down payments for kids’ houses must be planned for and based on realistic return assumptions. Cash should be put aside when a commitment is made.

Second, stick to your investment strategy. If you want to benefit from the long-term growth of stocks, you must remain invested. If you don’t think you’ll be able to withstand a sluggish, drawn-out bear market, you should consider reducing your stock weighting now. Selling after significant declines is guaranteed to cripple long-term returns.

And finally, don’t go into a shell. Too many investors stop reading their statements and try to ignore the bear. That’s a mistake.

Bad markets create opportunities and set up your portfolio for higher future returns, so you should keep to your contribution schedule and, after stocks have dropped, do some rebalancing to maintain your equity exposure.

You never want to go back up with less than you went down with.