Past Performance Is No Guarantee Of Future Results: Understanding Bear Markets

Wednesday, November 30, 2011 16:02
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Past Performance Is No Guarantee Of Future Results: Understanding Bear Markets

 

Due to recent market volatility, many are claiming that we are in a bear market. Although frightening, it isn’t the end of the world. In this climate, a financial advisor’s duty is to educate their clients about these turbulent periods and to prevent panicked investors from making poor choices.

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Below are some facts that financial advisors and investors alike should keep in mind.
 
Defining a Bear Market
There are a variety of definitions for a “bear market.” A bear marketis not the equivalent of a recession. One difference is that they have different signaling factors. Recessions have a beginning and end that an official or recognized institution acknowledges. According to Investopedia.com, a bear market is defined as: “A downturn of 20% or more in multiple broad market indexes, such as the Dow Jones Industrial Average or Standard & Poor’s 500 Index, over at least a two-month period.” Other definitions use a “peak-to-trough” approach, similar to Standard & Poor’s explanation: “A peak-to-trough decline of at least 20% of the S&P 500 Index.”When defining bear markets in history, the latter definition is typically used.
 
Determining the Length of a Bear Market
Since World War II, there have been 11 of these markets, which average a duration of 17 months. However, these troublesome times vary considerably in length, from 36 months beginning in 1946 to just three months in 1987. Since late July of this year, the S&P 500 has had an overall downward trend. As overseas markets are not fairing much better, many have called for individuals to fasten their seat belts and prepare for a bumpy ride. Others have denied the presence of a decline in our current economic future. For the sake of brevity, it is generally difficult (and sometimes controversial) to determine the span of these declines.
 
Thinking of Severity
Investors commonly ask, “How bad will the market get?” Again, there is no concise answer. Rate of return on investment in the S&P 500 Index measures severity. The average return of a bear market is
-32%, meaning that investments lose nearly one-third of their values. Severity and duration don’t always go hand-in-hand. For example, although 1946 has seen the longest bear market since World War II (36 months with a -30% return), the largest decline came in 2000 (30 months with a -49% return).
 
Recovering to Pre-Bear Market Levels
Even after reaching a trough, the market’s climb back to the level of its previous peak can be long. This increase is the “trough-to-peak” or recovery period. As S&P is quick to point out, “Different benchmarks and economic periods will produce different results.” For this reason, recovery periods also vary significantly. Although the bear market that began in 1973 only lasted for 21 months, it took a total of 69 months to recover to the previous peak level. Conversely, the 36-month decline of 1946 took just 15 months to recover to previous highs.
 
Learning from the Past
Despite the uncertainty that is indigenous to bear markets, one can learn many valuable lessons. Investors should avoid trying to “time the market,” since no onecan predict the end of a bear market with absolute certainty. Another mistake commonly made by investors is “anchoring” or incorrectly using a number or percentage as a point of reference. Short-term decisions made because of “anchoring” often endangers long-term growth.
 
Panicked investors can easily make poor decisions, but financial advisors must provide a historical prospective. In this way, investors can make more educated and more rational decisions about their portfolios and their economic futures. Remember, “Past performance is no guarantee of future results;” a bear market will not last forever.

 

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