Broker Check

Asset Allocation and the Psychology of Bull Markets

April 02, 2018

We are currently enjoying a bull market. This bull market started on March 9, 2009. It has been in full swing now for more than 8 years. I will never forget the day this bull market began, the sick feeling in my gut on the way home from work on that day marked the culmination of one of the worst bear markets of the modern era. The S&P 500 bottomed on that day after having fallen a stunning 57% from the high it reached on October 9, 2007. A $100,000 investment in equities is now worth a gut-wrenching $43,000. Well, that was then. Since then, the S&P 500 has risen more than 200%.

There is nothing like a nice, long bull market to help investors forget just how punishing a bear market can be. Equities are psychologically easy to own in a long bull market. Equities are so easy to own that many investors become over allocated to equities as a result. I can't tell you how often I see a 60-year-old-ish investor with 80 to 90% of her retirement portfolio allocated to equities. As equity markets rise, the equity exposure (risk exposure) of the portfolio is growing as well. The longer the bull market persists, the less thought we give to the potential damage negative volatility can inflict on our retirement capital. We know intellectually, that the equity markets can plunge at any moment but psychologically, making money is "oh so seductive". One of the toughest things for investors to do is move money out of equities as they are rising. But that is exactly what you must do if you hope to preserve some of those gains.

Let me state for the record, I am not calling for a dramatic market decline. I gave up trying to predict day-to-day market movements years ago. During my 30-year career in the financial services industry, I have experienced firsthand, three major bear markets: 1987, 2000, and 2007 plus a half-dozen nasty corrections. The most important lesson I have learned from those experiences is that no one sees a major market decline coming in advance including myself. Equity markets are short-term, impossible to predict. Therefore, we must preset and follow rigorous asset allocation guidelines in order to effectively control equity exposure and by extension, risk, over time.

Asset allocation guidelines provide us an objective standard to take emotion out of our investment decision making. For example, a 60-year-old investor might set an equity exposure range of 40 to 60 percent with 50 percent as the target. This discipline dictates a reduction in equites as the portfolio reaches the 60% level, no thought required. Conversely, during bear markets, you would add to equities as the exposure reaches the 40 percent level, again no thought required. This is an essential risk control discipline that should not be ignored no matter how alluring or frightening the markets may become.

Once a bear market begins, a fact that you won't know for sure until it's too late to avoid, the remedy is basically, to hold your equity position and ride out the storm. Since 1926 the average bear market takes about 12 months to bottom and about 24 months to recover. That's a total of 36 months from start to finish. This can easily extend to 60 months or more.

What is your plan to minimize the damage to your capital because of a significant and prolonged market decline? Set and then follow your asset allocation guidelines now while the sun is shining brightly and there are no clouds in the sky because when the storm clouds start rolling in, it might already be too late.

Call me if I can help. Keith Donnell MBA, CFP® (215) 990-2600