Bear markets can produce significant anxiety for investors. After diligently putting your money into the stock market, seeing your savings decline by 20% or more can be unnerving. It may induce so much fear that you stop putting your money into the market, waiting for a better time when things feel safe again.
But that could be a huge mistake. In fact, the period after a 20% decline in the stock market can be one of the best times to put excess capital to work. So, if you have cash sitting on the sidelines, it’s probably time to start buying.
Here’s what happens after a 20% decline in the market
Since the end of World War II, there have been 11 official bear markets, defined for these purposes as a 20% decline from a previous all-time high. If no new all-time high is set, we remain in the bear market. There have also been a few close calls in that time that some may consider bear markets even if they don’t fit the strict definition.
The challenge for investors, as Nobel Prize-winning economist Richard Thaler points out, is that it’s impossible to know whether we’re at the start of the bear market or if we’re close to reaching a bottom. Sometimes the bear market lasts months longer after the market’s already moved down 20% (like in 1973 or 2001), sometimes it’s only a few days (like in 1957 or 2020).
Here’s what we do know. On average, the year following a 20% decline produces better returns than the compound annual growth rate of the stock market since the end of World War II. Granted, it’s a small sample size, just 11 data points, but it’s a pretty wide margin.
The S&P 500 increased an average of 12.4% in the year following officially entering a bear market. Since September of 1945, the S&P 500 has grown at an average rate of 7.5% per year. (If you throw out the remarkable returns we saw following the coronavirus crash, the returns drop to 7.7% on average. But also removing the dismal returns from the 1973 crash, the average is bumped back up to 11.7%.)
Granted, it doesn’t always come out roses. Investors who bought into the bear market at the end of 1973 saw their investments decline another 28% over the following year. Those buying in at the start of 2001 amid the dot-com bubble bursting not only saw a decline of 11% over the following year, but the market was still down after three years and it had barely budged over the following decade due to the financial crisis of 2007-2008.
But more often than not, the market bounces back quickly, and it bounces back strong. There are six instances of one-year returns in excess of 23% following the entrance of a bear market. So, it usually pays to act fast.
It’s time to get greedy
There’s a lot of fear circulating around the market and the economy. Our current macroeconomic environment seems unprecedented, and nobody knows what will happen next. High levels of uncertainty create fear. But fear has to peak before we reach a market bottom.
That’s why Warren Buffett told Berkshire Hathaway shareholders his goal is “to be fearful when others are greedy and to be greedy only when others are fearful,” in his 1986 letter to shareholders.
It’s not time to abandon your plans of steadily investing into solid companies with strong financial footings or simply buying index funds and building a diversified portfolio. Sticking with your plan, perhaps even doubling down, is the best course of action in the face of a fearful market.
History shows the future expected value of every dollar you put into the market now is higher within a year than the average investment. Rest assured that investing in the market now is a great decision even if some part of you is fearing the bear.
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway (B shares). The Motley Fool recommends the following options: long January 2023 $200 calls on Berkshire Hathaway (B shares), short January 2023 $200 puts on Berkshire Hathaway (B shares), and short January 2023 $265 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.