"Financial Planning ... it's not always about money."

What Smart Investors Do in Bear Markets

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David M. Brenner, ChFC®, CLU®

D. M. Brenner, Inc.
Phone : (858) 345-1001
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Part of what makes bear markets so unbearable is that nobody—and I mean nobody—knows when or how they will end.


That doesn’t stop everyone on Wall Street from flogging measures, hunches and folklore purporting to foretell when stocks will finally stop falling.

However, intelligent investors don’t bother trying to predict the unpredictable; they focus on controlling the controllable. That’s the psychological key to surviving this—and any—bear market, no matter how long it lasts.

To see clearly why it’s so important to get your priorities straight, let’s look quickly at three beliefs about when bear markets end.

Ask any market veteran when stocks will start to recover, and you’re likely to hear something like this: Bear markets don’t end until individual investors throw in the towel, fear hits new heights or stocks finally get cheap again.

Taking each in turn, here’s why they’re myths.

Retail investors have to capitulate. Financial professionals love to argue that bear markets hit bottom when individual investors give up on stocks in a crescendo or “capitulation” of panic selling.

Only trouble is, that isn’t what happened in 1932, 1974, 1982 or 2002, among many examples. Bear markets sometimes end in a selling frenzy, but they often end in an indifferent stupor.

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Fear has to spike. Many professionals contend that the Cboe Volatility Index, or VIX, is “too low” right now, says Nicholas Colas, co-founder of DataTrek Research, an investment newsletter in New York.

The VIX, commonly called Wall Street’s “fear gauge,” spiked to then-record highs in October 2008, during the global financial crisis—but stocks still fell more than 19% before the bear market finally ended in March 2009.

“When markets are trying to reprice their expectations of the future, they only nibble away at that truth,” says Mr. Colas. No single indicator like the VIX can capture the moment when those expectations are about to shift.

Stocks have to get a lot cheaper. Many investors believe bear markets end only after formerly overvalued stocks finally become bargains again.

It just isn’t so.

In March 2009, in the pit of the global financial crisis, stocks traded at more than 13 times their longer-term earnings, adjusted for inflation, according to data from Yale University finance professor Robert Shiller. That was only about 20% cheaper than the average all the way back to 1881.

Although stocks didn’t seem like a statistical bargain at the time, they went on to gain roughly 15% annually over the next decade.

All this shows the folly of trying to figure out when stocks have hit bottom.

So you should distinguish what you can control from what you can’t. Instead of wasting your time trying to read the market’s tea leaves, take charge of the risks you run, the taxes you incur and your investing time horizon.

Being a buy-and-hold investor doesn’t obligate you to use a death grip. If some of your stocks or funds have performed abysmally in this downturn, you can sell them and reap significant benefits.

First, selling extreme losers will reduce your risk—and your anxiety about further losses in the future.

You probably regard your losers as liabilities because they can be so painful and embarrassing. In fact, you can readily turn them into assets.

Dumping your most dismal investments should enable you to book a loss. You typically can use this to offset capital-gains taxes on investments you sell at a profit, either this year or in later years.

You can also deduct up to $3,000 of those losses each year against your ordinary income, carrying any losses in excess of $3,000 forward to use as offsets against your taxable income in future years.

Another decisive step investors can take in a bear market is to consider converting a traditional individual retirement account into a Roth IRA.

In a Roth, your assets can grow without being currently taxed, just as in a traditional IRA. But withdrawals from a Roth are also tax-free, unlike in the traditional account, where your payouts are typically taxed at your ordinary-income rate.

That means a Roth could make sense for you if you expect your tax rates to be higher in the future.

The value of an IRA converted to a Roth “can blossom over time without any tax liability,” says Amy Barrett of Barrett Wealth Connection LLC, an investment adviser in Spring Grove, Ill.

You can also pass a Roth IRA to your heirs, who will be able to own and withdraw from it tax-free, effectively extending your investment lifetime for some years beyond your own.

Normally, the deterrent to converting a traditional IRA to a Roth is that the conversion is taxable at your ordinary-income rate.

Now that so many investments are down 10% to 20% or more, however, the amount on which you will be taxed is significantly lower, points out Melissa Labant, a tax principal at CLA LLP, an accounting and professional-services firm in Arlington, Va.

A Roth conversion is definitely not for everyone, though, and it can raise complicated tax technicalities. Make sure you walk carefully through all the implications with your accountant, tax adviser or financial planner before you pull the trigger.

So forget about squinting into a crystal ball to try figuring out when the bear market will end. Instead, control what you can.

Write to Jason Zweig at intelligentinvestor@wsj.com

David M. Brenner profile photo

David M. Brenner, ChFC®, CLU®

D. M. Brenner, Inc.
Phone : (858) 345-1001
Schedule a Meeting