Bear Market: Now What?

When the stock market drops 20% from a recent high, it's said to have fallen into a bear market. But what does such a large drop mean for the average investor? How long do bear markets usually last? How bad could a bear market get?

The first thing to note is that although they're relatively rare, bear markets aren't unusual. You might even say they come with the territory. Unfortunately, acknowledging their historical inevitability is cold comfort at best.

The individual investor isn't entirely powerless in the face of a bad market. Here, we answer some common questions about bear markets and how best to confront them.

Historically, the stock market has always returned to its previous peak after a bear market, usually within a few years. The Schwab Center for Financial Research looked at both bull and bear markets for the S&P 500^® Index going back to the late '60s and found that the average bull ran for about six years, while the average bear market lasted roughly 15 months. The longest bear market lasted about two and a half years. The shortest was the pandemic-fueled bear market in early 2020, which lasted a mere 33 days.

A diversified portfolio can't guarantee you'll never have losses—but it can help cushion them. In every bear market some asset classes get hit much harder than others. Of course, the current situation is exceptional because there have been few safe havens. Stocks and bonds have both dropped, and while cash has been stable in nominal terms, its return after inflation is currently negative. Cryptocurrencies, positioned by some as a hedge against traditional investments, have turned out to be nothing of the sort. However, the situation is evolving and the fundamental logic underlying diversification is still sound.

Think of it like this: It's extremely difficult to forecast when any particular asset class will leap out of a bad market—or fall into one—so keeping your portfolio diversified within and across asset classes can help you stay positioned for whatever comes next.

Bear market recoveries are often front-loaded, with much of the gain seen in the early days. Selling otherwise promising stocks during a down market not only locks in losses, but also raises the risk you may miss key days of the recovery, which can have a significant impact on performance.

To offer a sense of what's at stake when you pull out of the market, even temporarily, during the average bear market, the Schwab Center for Financial Research compared the returns from four hypothetical portfolios: 

• One that remained 100% invested in stocks as the market touched its bear-market low and then rebounded. (While we recommend diversifying your portfolio with a mix of assets appropriate for your goals and risk tolerance, we're focusing on stocks here to illustrate the impact of market timing.)
• One that was diverted to short-term Treasury bills (T-bills) for a month after the market bottomed before returning to a 100% stock allocation.
• One that was diverted to T-bills for three months after the market bottomed, before returning to a 100% stock allocation. 
• One that was diverted to T-bills for six months after the market bottomed, before returning to a 100% stock allocation.  

As you can see in the table below, the all-stock portfolio was the best performer and was still delivering higher returns than the other portfolios three years after the market bottomed. But investors in that all-stock portfolio had to stay invested at literally the lowest point of the market cycle. Those who waited until the skies were clearer (e.g., a month after the low point of the cycle, or three months, or even six months) still participated in the recovery. They just earned lower returns. Of course, this doesn't mean you should take on more risk than you can handle both emotionally and financially. Just be careful about sharply and suddenly changing your risk exposure solely in reaction to difficult market conditions.

One way to manage investing risk during a volatile market is to use "dollar-cost averaging." The idea is to invest a set amount of money at regular intervals no matter how the stock market is performing. With this approach, you will be able to buy more shares when prices are lower, and fewer shares when prices are higher.

For those who are instead considering changing the amount of risk in their portfolio, we would suggest starting by making small changes rather than a large dramatic shift. Then they can reevaluate at a future date.

Another approach would be to make small shifts within asset classes. For example, you could move some of your bonds into a sub-asset class within the bond market that looks more attractive given current conditions.

Finally, if there's one potential upside to a down market it's that losses create opportunities for tax-loss harvesting. This involves selling securities that have dropped in value below their purchase price, and then using that loss to offset any taxable gains and/or up to $3,000 of ordinary income. Then you would replace that security with a similar security that will allow you to participate in any future recovery.

Anything you can do to avoid selling investments when the market is down could potentially extend the life of your savings. Think of funding your retirement as a kind of business: When times are bad, your first response should probably be to trim your expenses.

Then, if you're able to do so, you may want to consider scaling back a planned withdrawal or even skipping it. You could also forgo inflation adjustments or postpone large expenses. If you do need to sell assets, be sure to go about it in a way that minimizes the damage to your portfolio.

Why? When you tap your portfolio as it's losing value, you have to sell more investments to raise a set amount of cash. Not only does that drain your savings more quickly, but it also leaves you with fewer assets that can generate growth and returns during potential future recoveries. The risk of taking too much out of your portfolio too soon is especially acute if you're in the early years of your retirement.

In contrast, if a decline occurs later in your retirement, you may not need your portfolio to last as long or continue growing to fund a long retirement, so you may be in much better shape to fund withdrawals.

One way is to set up a low-risk, liquid reserve to cover near-term expenses—for example, 12 months' worth of expenses in cash investments (e.g., yield-bearing checking or savings account), and another three to five years' worth of expenses in high-quality short-term bonds and cash equivalents (such as certificates of deposit). This can help you avoid selling riskier investments, such as stocks, at depressed prices.

Rebalancing at regular intervals or whenever your portfolio deviates significantly from your target asset allocation is a good idea, and it tends to work best when you stick to a disciplined strategy. Like any investment decision, it shouldn't be driven by emotion or panic.

A quick primer on rebalancing: As markets change, your allocation can drift away from its original target. Over time, assets that have gained in value will account for more of your portfolio, while those that have declined will account for less. This can leave you exposed to unintended risk if the market environment should suddenly change. Rebalancing means selling positions that have become overweight in relation to the rest of your portfolio, and moving the proceeds to positions that have become underweight.

Rebalancing at a predetermined time each year can help prevent impulsive investing decisions and keep your long-term goals on track. Schwab clients can log in and use the Schwab Portfolio Checkup tool to identify areas of their portfolio that may have veered away from their target asset allocation.