Sharing an excellent (edited) post from the folks at RIA Advisors...

Bear Market Wealth Management

By Michael Lebowitz and Lance Roberts of RIA Advisors | August 31, 2022

Growing wealth happens over decades. Within these decades are many bullish and bearish cycles. While investors tend to focus on making the most of the bullish cycles, it is equally important to avoid letting bear markets reverse your progress. The amount of time spent in bear markets is minimal, but the time lost recovering your wealth can be substantial. Given the possibility that we are in the early innings of a bear market, it is worth revisiting bear market wealth management strategies and the math showing why such a strategy is essential.

Is This Time Different?

Over the last two decades, investors have gravitated toward passive buy-and-hold strategies. Who can blame them? Such strategies allow investors to sit back and relax. Avoiding having to time markets and picking winning stocks is not only simple, but it has been effective.

Passive buy and hold strategies work in large part because the low inflation regime of the last thirty years allowed the Fed to support markets with plenty of excess liquidity when markets felt some turbulence. Low-interest rates and QE support high valuations and asset prices.

Is the low inflation regime changing? In Persistent Inflation Scares The Fed and Deglobalization and Central Banking, we make a case that a persistent price-wage spiral and deglobalization may cause inflation to run hotter than it has in quite a while. Instead of assuming inflation will normalize and monetary policy will return to normal, we must ask tough questions.

• What if inflation proves persistent and doesn’t retreat by as much or as fast as investors expect?

• What if central bankers must keep administering the harsh monetary medicine the markets are struggling to digest?

As we wrote in Deglobalization and Central Banking:

They (central bankers) are very adept and have the tools to control demand. They do not have the tools to manage supply. We are potentially on the cusp of enormous change.

Persistently higher inflation may keep the Fed focused on the prices of goods and less so on asset prices. Passive strategies in such an environment will likely have much less success than it has during most of our careers. Bear market wealth management strategies may be the key to keeping your wealth goals on track.

The Compounding Math Supporting Bear Market Wealth Management

We share two simple scenarios to explain why actively managing risk exposure and limiting drawdowns in a bear market is so important. In both scenarios, we initially invested $10,000 in 2004. Scenario A is a buy-and-hold passive portfolio. It is fully allocated to the S&P 500 at all times. The Scenario B portfolio is fully allocated to the S&P 500 at all times except during the bear market of 2008. During that period, scenario B’s portfolio has a 50% allocation to the S&P 500, with the remainder in cash earning 0%. We reinvest dividends in both scenarios.

The graph below shows that by simply cutting equity exposure in half for less than two years, scenario B’s value is currently 41% more than scenario A.

A bear market wealth management strategy is simple with 20/20 hindsight. In reality, we know that getting in and out of markets at the exact top or bottom is impossible. The point of the example is to show that any reduction of exposure will diminish your losses. Accordingly, it leaves you more wealth to invest when the bull market returns.

To boil this down, all we did was cut our exposure in half for two years over 18 years. As a result, our wealth was 41% greater than it would have been. Had we reduced our exposure more and acted similarly in 2020 and 2022, the relative returns would have been even better.

Any reduced exposure to stocks in a bear market leaves more money to buy stocks when prices are lower. The advice is so simple yet so hard for many investors to follow.

The mutual fund complexes and banks and brokers want commoditized markets. What better way than passive strategies to create a one size fits all approach? While buy and hold and other passive strategies may help their bottom lines, they are not always best for your bottom line.

Buy and Hold vs. Bear Market Wealth Management

Nothing is complicated about a bear market wealth management strategy, but it differs vastly from a buy-and-hold passive approach.

Bear market strategies boil down to managing equity (and bond) exposure.

(EDITOR’S NOTE):

Seeing a marked deterioration in trend quality, we began reducing our exposure to stocks and bonds during 4Q 2021. Our primary long-equity strategies (Sharpe Factors and Sharpe Reversion) are both sidelined so far this year, as are two bond strategies (Haven Sent and Fixed Dynamic). Trend filters turn the strategies “on/off.”

We currently maintain large cash holdings and utilize two short-equity strategies (Avalanche and Get Shorty), plus a flexible allocation strategy (Macro Mojo), to manage risk.

We are also deploying derivative option strategies for hedging and speculation.

As a result, we are handily outperforming all primary stock and bond indexes year to date.

Stick To Your Process

There is a sizable contingent of investors, and advisors, who have never been through a real bear market. Therefore, it remains important to follow your investment discipline. If you don’t have one, here is the process we follow during tough markets.

1. Move slowly. There is no rush to make dramatic changes. Doing anything in a moment of “panic” tends to be the wrong thing.

2. If you are overweight equities, DO NOT try and fully adjust your portfolio to your target allocation in one move. Again, after big declines, individuals feel like they “must” do something. Think logically above where you want to be and use the rally to adjust to that level.

3. Begin by selling laggards and losers. These positions were dragging on performance as the market rose, and they led on the way down.

4. Add to sectors, or positions, that are performing with or outperforming the broader market if you need risk exposure.

5. Move “stop-loss” levels up to recent lows for each position.

6. Be prepared to sell into the bull rally and reduce overall portfolio risk. There are many positions you will sell at a loss simply because you overpaid for them to begin with. Selling at a loss DOES NOT make you a loser. It just means you made a mistake. Sell it, and move on with managing your portfolio. Not every trade will always be a winner. But keeping a loser will make you a loser of both capital and opportunity.

7. If none of this makes sense to you, please consider hiring someone to manage your portfolio. It will be worth the additional expense over the long term.