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When it comes to understanding market risks and their impact on investment success, there is an elephant in the room—or rather, a bear. A “bear market” occurs when there is a greater-than-20% peak-to-trough drop in the S&P 500. Although the 20% threshold is arbitrary, crossing this level has historically been an important dividing line between painful-but-short-lived corrections—where recovery time is measured in months—and the years-long recovery period for bear markets.

Although they are a natural part of the investing experience, there’s a certain taboo about discussing bear markets and recessions, as if acknowledging them increases the likelihood of experiencing one. Our research suggests that this taboo is counterproductive. In studying bear markets closely, you will learn that they aren’t as dangerous as they seem.

It’s important to note that there is no panacea for bear markets. Almost all investors will experience at least a handful of bear markets—both in their working years and during retirement—and they will be painful. But there’s a difference between pain and damage, and our research tells us that bear market protection doesn’t have to be expensive—especially if investors are proactive.

As we’ll show below, bear markets needn’t be a threat to financial success. In fact, for the well prepared, they can be an opportunity to improve long-term returns. After reviewing this research, you can work with your financial advisor to make sure you’re prepared. It’s never too early—and rarely too late—to plan.

We define a bear market as an episode where US large-cap stocks fall by at least 20% from peak to trough. Rather than focus only on the peak-to-trough drop time period—what we call the “drawdown” period—we also include the time that it takes for stocks to register another all-time high—what we call the “recovery” period.

The 20% threshold may seem arbitrary, but it is useful because it filters out a large number of painful-but-short-lived drawdowns for that asset class. For drops greater than 10%, but less than 20%, we generally call them “bull market corrections.” For less-than-10% drops, there are no agreed-upon definitions. Sell-offs of this magnitude are fairly common, and short-lived, and usually earn names like “dip,” “sell-off,” “reversal,” “pullback,” or “slide.”

It’s also important to note that, generally speaking, risk and return parameters are not relevant if we apply them directly to other asset classes or portfolios. After all, a “big” percentage change for one asset class may be a relatively minor move for another asset class or investment strategy. So while we use US large-cap stocks as the basis for defining bear markets, this is only for clarity, not because we’re suggesting that investors should measure their performance against an all-equity benchmark like the S&P 500.

With this definition in mind, let’s look at historical returns to evaluate what market cycles look like using our framework.

Unfortunately, history tells us that the quest for “the perfect hedge” may be a wild goose chase. No matter how well intended or designed, the strategies that provide the most potent protection against equity downside risk also tend to be the most costly in terms of sacrificing long-term growth potential.

That’s particularly true if the goal is to hedge against all downside movements, instead of only against the long and deep sell-offs that characterize bear markets. That’s because—in order to make sure that there is a high negative correlation during all downside episodes—a strategy must risk also having a high negative correlation when markets go higher. In a world where stocks usually go higher, strategies that seek to go “short” or directly hedge equities seem doomed to fail. This cost is especially high for strategies that employ leverage to “make the most” of their short windows of opportunity.

As a result of these challenges, we don’t usually recommend direct hedges as a part of our strategic or tactical asset allocation. As we will note below, it’s important to prioritize cost-effective protection before moving onto less-reliable or costlier hedging strategies.

Here are some “damage mitigation” strategies, in declining order of efficiency:

There are a handful of tactics that investors can employ during a bear market.

Liquidity. Longevity. Legacy. disclaimer
Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.