The risk of equity price volatility is always present. The following table shows that equity prices experience three to four declines of greater than 5% each year, one decline of greater than 10% approximately each 12 months, and a bear market decline of greater than 20% every three to four years. Predicting when these declines begin and end has proven to be a “loser’s game.” Equity investors have been rewarded for assuming price volatility through higher returns over time.

The S&P 500 last experienced a greater than 20% decline from October 2007 to February 2009. Investors who bought stocks at the peak in October 2007 had to wait until March 2012, approximately 4.5 years, for the value of their investment to rise above the original cost through both dividend re-investments and price movements. This example illustrates the importance of matching time horizons with the risk of price volatility. As a general rule, investors can invest funds that they do not expect to spend over the next five years in equity oriented investments.

Minimize the Probability of a Permanent Loss of Capital

Price volatility only turns into a permanent loss of capital if the investor sells securities after prices fall below the original costs. This risk can be minimized by accepting price volatility, knowing your tolerance for anxiety during bear markets, and owning an effectively diversified portfolio.

Accept price volatility

Try not to dwell on short-to-intermediate-term performance. When you invest in a broadly diversified portfolio of stocks, price fluctuations generally reflect emotional reactions to current events or the near term outlook, rather than changes that affect the long-term aggregate value of the companies in your portfolio. Long-term growth in corporate profits primarily drives the total value of equity prices higher.

Know your bear market tolerance

The large number of financial markets prognosticators assures that someone, reasonably accurately, predicts when every bear market begins. For example, Nouriel Roubini published a paper in early 2008 titled: The Rising Risk of a Systemic Financial Meltdown.

Unfortunately most investors did not know or care about Roubini’s views until late 2008 when his thoughts were summarized as: “we are going to have what he calls “stag-deflation,” meaning severe stagnation and deflation. Basically, he thinks that we're heading into a depression without extreme government action. He's also warning of possible food riots.” Roubini “predicted” the financial crisis, but people who followed his views either sold equities in late 2008/early 2009 and turned unrealized losses into permanent losses of capital or missed a great investment opportunity in February 2009.

Bear markets happen. The same person does not ring a bell at the beginning and end of a bear market. Additionally, you will not know who correctly rang the bell until after the events have occurred. Instead of trying to “time the market,” determine if you can accept the anxiety created by a bear market with 100%, 60% or 20% of your portfolio invested in equities during the decline.

Diversify

Effective diversification simply means investing in a variety of assets, with the expectation that positive performance for some investments will neutralize negative performance for others. The goal of diversifying is to build a portfolio that includes investments that react differently to the same economic factors, limiting the risks associated with “putting all your eggs in one basket.”

Beyond the major assets classes, you can diversify even further by allocating your money to different subclasses. For example, an equity portfolio can be subdivided into domestic vs. foreign companies, large cap vs. small cap equities and growth vs. value styles. The subclasses often perform differently, the essence of effective diversification.

As noted earlier, US large cap stocks as represented by the S&P 500 have not experienced a bear market since 2008. In contrast, foreign stocks, small cap stocks and value styles all experienced greater than 20% declines from May 2015 to February 2016. When the S&P 500’s next bear market decline occurs, foreign, small cap and value styles may dampen the impact on a global equity portfolio tilted toward small cap and low priced stocks.

Conclusion

The higher expected return for equity securities compensates investors for assuming uncertainty about the timing and magnitude of returns. Accept price volatility, mentally prepare yourself for the next bear market decline and own a globally diversified portfolio of equity securities. Most important, your portfolio should include short-to-intermediate-term investment grade bonds to meet your anticipated spending needs over at least the next five years.