Investors are understandably frustrated by a miserable year in which stocks are in a bear market and bonds have provided no relief. It is hard not to be pessimistic given the long list of concerns that dominate the market outlook – most notably inflation, central bank policy and war in Ukraine. Despite this painful year for investors, it is important to maintain a long-term perspective while taking constructive actions that will help in navigating a bear market.
1. Use an Appropriate Frame of Reference When Evaluating Investments.Investors frequently compare their holdings to the S&P 500 Index, which is not always the appropriate comparative index for an investment strategy. For example, investments outside the U.S., in small-company stocks or in value stocks should be compared to a more relevant benchmark for the investment universe or style.
Many investors also are too quick to embrace short-term success or punish short-term failure. According to Oaktree Capital Management’s Howard Marks (opens in new tab), “Every portfolio and manager will experience good and bad quarters and years that have no lasting impact and say nothing about the manager’s ability.”
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2. Take Advantage of Opportunities to “Harvest” Losses.Bear markets create a lot of “losers” in which current market value is below the holding’s cost basis. A silver lining associated with losing investments is the opportunity to realize capital losses to lower future tax liability. Tax loss harvesting involves selling a position that is trading at a loss, creating realized losses that can be used to offset taxable capital gains or a limited amount of ordinary income.
Unused tax losses can be carried forward to future tax years. When harvesting losses, it is important to avoid violating the wash sale rule, which disallows losses for current income tax purposes if you sell a security at a loss and buy the same or a “substantially identical” security within 30 days before or after the sale.
3. Distinguish Between Patience and Complacency.Patience is a virtue for investors, as stocks should continue to be viable long-term investments.
Complacency, however, can be a trap for investors. There are changes in the investment environment that are likely to last beyond this year’s bear market and may necessitate course adjustments for long-term investors. For example, inflation may be a more persistent challenge than deflation over the next decade. Consequently, investors should consider adding investments that provide inflation protection and inflation-adjusted income.
The war in Ukraine and rivalry between the U.S. and China will also create long-term investment changes, with winners and losers likely to emerge because of fundamental changes in the investment environment.
4. Avoid Relying Solely on the Recent Past as a Guide to the Future.Most investors assume that bonds provide a reliable counterweight to stocks, as for most of the past two decades, bond prices have tended to rise when stock prices fall.
However, “recency bias” in assuming that negative correlations between stocks and bonds will persist can be a trap for investors. For much of history, in fact, the correlation was positive, with stocks and bond prices advancing or declining together.
5. The Last Tip May Be the Most Important: Differentiate Between the Stock Market and the Economy.Stocks tend to bottom several months (at least) before the rest of the victims of a recession. The end of the bear market may occur despite bad news on profits, GDP and payrolls. The turning point in markets often comes when the news becomes “less bad” than investors fear or when worst-case scenarios become less likely.
For example, during the early days of the pandemic, markets rebounded strongly after the Fed took decisive action to prevent a liquidity crisis from becoming a solvency crisis and fiscal spending provided support to struggling households.
In the current environment, the removal of worst-case scenarios regarding inflation, Fed policy or war could be what turns investor sentiment from pessimism to optimism.
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC (opens in new tab) or with FINRA (opens in new tab).