A bear market is defined as a prolonged decline in the stock market and generally refers to a 20% fall in stock market value. A bear market is a great opportunity to rebalance your retirement portfolio in order to give you the highest returns when you ultimately retire.
- A bear market represents a buying opportunity for your retirement account
- In a bear market, the value of stocks tend to fall more than the value of bonds
- By rebalancing your retirement portfolio, you can purchase stocks when they are inexpensive and increase the overall value of your portfolio when you ultimately retire
Last month, I outlined why a bear market is the perfect time to convert a traditional IRA into a Roth IRA in order to reduce the total amount of investment taxes you pay over your lifetime. Although a bear market Roth IRA conversion will reduce your taxes, it will not improve your overall investment returns when you eventually take the money out in retirement. But rebalancing your investments during a bear market can improve those long-term retirement portfolio returns.
What is rebalancing?
Traditional investment wisdom calls for the wise investor to “buy low and sell high”. In the short-term, it is nearly impossible for any investor to know whether the value of an investment is going to go up or going to go down. However, in the long-term, the value of broad stock and bond indices always goes up. When a broad stock market index falls into bear market territory, then you know that you have an opportunity to ‘buy low’.
My own investment philosophy has been to buy some shares of a stock index fund whenever the S&P 500 index drops in value by 10%. When the S&P 500 drops by 20%, I buy as much as I can. When the stock market drops that much, I consider stocks to be on sale. This strategy has served me very well over the past 30 years. There are two ways to buy stocks – either purchase them using your cash savings or purchase them by exchanging shares of bond investments for shares of stock. If buying stocks with cash savings, don’t forget to always keep enough in cash reserves to cover 3-6 months of expenses. In other words, don’t sacrifice your emergency fund to take advantage of a bear market.
If you do not have enough cash savings to buy stocks, then you can still exchange bonds for stocks and that is where rebalancing comes in. Rebalancing means maintaining a constant stock:bond ratio in your portfolio. For example, if you had previously been maintaining a retirement portfolio of 70% stocks and 30% bonds and then the value of the stock component increases during a bull market, then your portfolio could end up being 75% stocks and 25% bonds. In this case, you would want to exchange some of your shares of stocks for shares of bonds so that you can restore your desired 70/30 stock:bond ratio.
Why rebalance now?
In the past six months the value of both stocks and bonds has fallen and we have now entered a bear market. However, stocks have fallen much more than bonds and as a result, many investors are now finding that the relative percentage of bonds in their overall retirement portfolio has increased and the percentage of stocks has decreased. Let’s use the Vanguard Total Stock Market Index Fund as a measure of overall stock market performance and the Vanguard Total Bond Fund as a measure of overall bond market performance:
Since the beginning of 2022, the Vanguard Total Stock Market Index Fund has fallen in value from $118.25 per share to $89.48 per share, a 24.3% reduction. During that same time period, the Vanguard Total Bond Fund has dropped from $11.10 per share to $9.80 per share, an 11.7% reduction. In other words, stocks have fallen in value more than bonds.
If the stock:bond ratio in your retirement portfolio was 70/30 on January 1, 2022, it has now fallen to 66.7/33.3. In order to rebalance and restore your portfolio to the desired 70/30 ratio, you need to exchange some of your bond investments for stock investments. Once you do the math, this means that if your total retirement portfolio is worth $100,000, you should convert $3,335 of your bond investments into stocks. If your portfolio is worth $500,000, you should convert $16,675 of bonds into stocks. And if your portfolio is worth $1,000,000, you should convert $33,350 of bonds into stocks. Investors who should exchange the most from their bond funds into stock funds are those who originally had a 50/50 stock:bond mix in January as shown in the table below:
From this table, it is clear that the current bear market has left all portfolios out of balance and just about everyone’s retirement portfolio is now too heavy in bonds. So, we should all be converting some of our bond investments into stock investments right now. How much to convert depends on what your desired stock:bond ratio is.
How long do bear markets last?
One of the problems with entering a bear market is that you cannot predict how much further the price of stocks will fall before they bottom out. The price of stocks could start to increase tomorrow or maybe not until 2024. No one has a crystal ball that can see into the future and anticipate all of the thousands of variables that affect the price of stocks. However, we can look back to history to see how other bear markets have behaved. Since 1950, there have been eleven other bear markets that have lasted anywhere from 1 month to 2.6 years. The time that it takes for full recovery from a bear market has taken anywhere from 3 months to 5.75 years.
Given the uncertainty regarding the duration of our current bear market, one tactic could be to incrementally rebalance your retirement portfolio over the next several months. That way, if the value of the stock market continues to fall, you can take advantage of lower stock prices.
Know your investment time horizon
Investment pundits often talk about the investment time horizon in terms of the number of years until retirement. I believe that a better investment time horizon is the number of years until death. No one withdraws all of their retirement investments on the day that they retire – those investments have to keep earning returns for your entire remaining life. Obviously, you can choose your retirement date but you can’t choose your death date. But if you believe that there is a reasonable chance that you will live to be 95 years old, then you have a longer investment horizon than if you do not believe that you will live past age 70. It is that investment horizon that should dictate your retirement portfolio’s stock:bond ratio.
The decision about whether or not to rebalance your stock:bond ratio should not depend on your investment horizon. It is just as important to rebalance if you are 80 years old as it is if you are 30 years old. Those investors with a short time horizon should have a relatively higher percentage of their retirement portfolio in bonds than investors with a long time horizon. This insulates the short horizon investor from the worst effects of bear markets. Although short horizon investors’ portfolios have dropped in value, their portfolios have not fallen as far as portfolios of investors with a long investment horizon (who have a high percentage of their portfolios in stocks). This is illustrated in the table below, again using the Vanguard Total Stock Market Index Fund as a measure of stock performance and the Vanguard Total Bond Fund as a measure of bond performance:
A retirement portfolio that was valued at $100,000 on January 1, 2022 would now be worth $769 if the investor had a 90/10 stock:bond ratio whereas it would be be worth $870 if the investor had a 10/90 stock:bond ratio.
What is the best stock:bond ratio?
In a previous post, I discussed the factors that should determine what the ideal stock:bond ratio should be for any given investor. The most important determinate is your investment horizon which is generally tied to your age.
However, age alone should not be the only determinant of your retirement portfolio’s stock:bond ratio. Equally important is your personal degree of investment risk. Investors who should adopt a low risk portfolio include those who get anxious about market volatility, are pessimistic about the future economy, lack a pension, anticipate a short life expectancy, and have annual living expenses that are close to their annual retirement income. On the other hand, investors who can adopt a high risk portfolio include those who do not get anxious about market volatility, are optimistic about the future economy, have a pension, expect to live to an older age, and have annual retirement income that substantially exceeds their annual living expenses.
Those investors who adopt a low risk portfolio are those who need the relative safety of bonds in the event of a protracted bear market whereas those who adopt a high risk portfolio are those who can afford to ride out a long bear market without fear of running out of money later in retirement. It is important to note that an investor’s personal degree of investment risk should not affect the decision about whether to rebalance their portfolio. Every wise investor should rebalance in a bear market. One’s willingness to take investment risk should only affect their desired stock:bond ratio.
The stock:bond ratio is an oversimplification of most retirement portfolios. A healthy portfolio should consist of U.S. stocks, U.S. bonds, foreign stocks, foreign bonds, and real estate. Some investors may also include commodities, gold, collectibles, etc. No matter what your retirement portfolio is composed of, you should always know what the ideal percentage of your portfolio should be in each type of holding, based on your age and personal investment risk. You should then periodically rebalance those holdings in order to ensure that the percentage of each component stays constant.
Bears are scary animals and bear markets are scary financial times. Although it is easy to be frightened when you look at your finances right now, the current bear market should be viewed as an opportunity to increase long-term returns from your retirement investment portfolio.
June 21, 2022