An important but often overlooked benefit of SMI’s investing strategies is they provide clear-cut boundaries. These boundaries protect us from our worst enemies — ourselves — by giving “mechanical” guidelines for buying and selling. Following the guidelines increases the likelihood of reaching one’s investing goals. However, when severe bear markets come, some investors start ignoring the guidelines.
With many investors growing concerned about the end of the bull market, here are our thoughts on setting — and maintaining — appropriate boundaries.

When this article was originally begun in early August, it felt a bit odd to be writing about bear-market preparations with the stock market only 2% below its all-time high. At the time, we were a long way from bear-market territory, which is conventionally defined as a drop of 20% or more from the high. Then the market started falling on August 20, and again on the 21st, and opened with the Dow down 1,000 points on Monday the 24th. Suddenly, our effort to get you planning for the next bear market seemed much more relevant!

One of our goals at SMI is to help members think a step ahead, and one way we accomplish that is by trying to counterbalance the dominant emotion of the moment. That means trying to keep you from overreacting out of fear when we’re actually in a bear market by focusing on the buying opportunity rapidly approaching. But it also means gently reminding you that six-year bull markets won’t last forever. There will be another bear market, and when it arrives we want you to be prepared in advance, not reacting emotionally in the heat of the moment.

The other motivation for writing this article now is that it seems investors have been growing increasingly fearful of what the next few months may hold, despite the market continuing to perform well (until the past few days). The long-anticipated Federal Reserve interest-rate hikes seem imminent, undercutting the “easy money” policies that many have viewed as the primary catalyst of this bull market. A mix of traditional factors (market valuations, the September/October reputation for being volatile and crash-prone) and non-traditional factors (Christian-specific issues that some believe heighten the risk to the market this fall) are causing some investors to consider whether they ought to take pre-emptive action to protect their portfolios. Individual attempts at market-timing rarely end well, so here is our attempt to present a reasonable framework for those considering taking defensive action.

Biblical principles of investing

Before getting into specifics, let’s first recognize what we’re up against. As investors, we are our own worst enemies. This observation stems not only from our decades of practical experience as investors and money managers, but also is confirmed by God’s Word. Given our fallen natures, it would be surprising if we weren’t the primary problem we face when investing. Consider for a moment the kind of people we are.

  • Our wisdom is flawed.
    “Let no person deceive himself. If any one among you supposes that he is wise in this age, let him become a fool [let him discard his worldly discernment and recognize himself as dull, stupid and foolish, without true learning and scholarship], that he may become [really] wise. For this world’s wisdom is foolishness (absurdity and stupidity) with God” (1 Corinthians 3:18-19, Amplified).
  • Our motivations are impure.
    “The heart is deceitful above all things, and it is exceedingly perverse and corrupt and severely, mortally sick! Who can know it [perceive, understand, be acquainted with his own heart and mind]?” (Jeremiah 17:9, Amplified).
  • Our emotions are powerful.
    “For I know that nothing good dwells within me, that is, in my flesh. I can will what is right, but I cannot perform it. I have the intention and urge to do what is right, but no power to carry it out” (Romans 7:18, Amplified).
  • Our vision is limited.
    “Come now, you who say, ‘Today or tomorrow we will go into such and such a city and spend a year there to carry on our business and make money.’ Yet you do not know [the least thing] about what may happen tomorrow ....You boast [falsely] in your presumption and your self-conceit” (James 4:13-14, 16, Amplified).

Obviously, these failings create a predicament. As we try to make good investing decisions, we’re handicapped by insufficient wisdom, misguided motives, unhelpful emotions, and a complete lack of clarity as to what the future holds.

Fortunately, God has given us protective principles in His word. These provide boundaries that serve to safeguard us from the markets and ourselves. The reason for having an individualized investment strategy is to put these needed boundaries into place in a practical way.

In Changes That Heal, psychologist Henry Cloud describes boundaries this way:

Boundaries, in a broad sense, are lines or things that mark a limit, bound, or border. In a psychological sense, boundaries are the realization of our own person apart from others. This sense of separateness forms the basis of personal identity. It says what we are and what we are not, what we will choose and what we will not choose, what we will endure and what we will not, what we feel and what we will not feel, what we like and what we do not like, and what we want and what we do not want. Boundaries, in short, define us. In the same way that a physical boundary defines where a property line begins and ends, a psychological and spiritual boundary defines who we are and who we are not.

Setting protective boundaries

Having a personalized investing plan built upon SMI strategies such as Dynamic Asset Allocation (DAA) or Fund Upgrading, helps contain and focus your impulses by providing boundaries. Yes, a plan does box you in and take away your freedom to do whatever you might want, but it offers a new kind of freedom — the freedom to do what you should. A plan gives you a sense of perspective and a way of knowing what’s “right” for you. Let’s look at four boundaries provided by SMI’s strategies.

  • Using mechanical guidelines rather than your own intuition and judgment.
    Mechanical guidelines require that you develop objective criteria for buying and selling decisions. They help you harness the powerful emotions that can propel investors to do precisely the wrong thing at precisely the wrong time. Mechanical rules may appear dull, but that’s a virtue — the most successful market strategies tend to be dull because they are measured, not spontaneous.
  • Building a broadly diversified portfolio to protect against the uncertainties of the future.
    Acknowledging your limited vision is to be honest with yourself and say, “Not only do I not know what the future holds, none of the experts do, either.” Since we can’t know the future, we can never know in advance with certainty which investments will turn out most profitably. That is the rationale for diversifying — spreading your portfolio into various risk categories as we recommend in Upgrading (see page 138), or among totally different types of assets, as we do in DAA. By doing this, you won’t be overinvested in any hard-hit areas.

    Once you accept that “nobody knows,” it makes a lot of sense to diversify and relax. Then, you’re free to ignore all forecasts by the “experts.” There’s a kind of Newton’s Law of Motion for economics: For every forecast by a group of experts with impressive credentials, there’s an equal and opposite forecast by another group of experts with equally impressive credentials. Besides, if you’ve ever noticed, most forecasts seem to assume that the current trends (whatever they are) will continue. If they were to have any value, we’d need to know when the current trends will be reversed!
  • Developing a long-term, get-rich-slow perspective.
    Fewer things cause investors more losses than a short-term, get-rich-quick orientation to decision making. Patience, a fruit of the Holy Spirit, is in short supply among investors today. A long-term view is extremely productive when investing; such a perspective allows you time to do first things first, such as dealing with getting debt-free and building an adequate emergency fund. Once that foundation is laid, you can handle market risk with greater confidence. In the face of market setbacks, a long-term view says, “I’m investing with my surplus funds. This sell-off is no threat to my immediate well-being. I’ve got time to be patient and wait for the recovery.”

    A long-term view also allows you to be more relaxed when your judgment turns out less than perfect (surprise!). For example, those times when the fund you just bought goes lower (which it always will) or the one you just sold goes even higher (which it always will). Why let that frustrate you? In your saner moments, you know it’s extremely unlikely you’re going to buy at the exact low or sell at the exact high. Taking the long view says, “It doesn’t matter whether I bought at $14 when I could have bought at $12. The important thing is that I followed my plan. Over time, I know my plan will get me where I want to go.”
  • Accepting management responsibility for your decisions.
    Ultimately, you are accountable for what happens. You have been given a stewardship responsibility that you cannot delegate away. You can delegate authority to someone else to make certain investment decisions, but you cannot delegate your responsibility for the results that come from those decisions. Many Christians do not see themselves as “investors” simply because they don’t have large stock portfolios. They have a misconception as to what investing involves: In essence, investing is simply deciding what you will do without today so that you might have more of something later. We’re all investors at some level.

    Managing this part of your life responsibly is a God-given task. Recognizing that will help you become more realistic about your need to study the basics and create a plan for making important decisions. In the process, you’ll learn that rates of return over the long haul tend to be in the 8%-10% range, not 15%-20% as many imagine. The idea that you will readily make large returns to bail you out of your problems is a dream. And mixed in that 8%-10% average will be good years (gains of 20% to 40%) and bad years (losses of 10% to 30%). It’s not a smooth road. However, following a personalized, biblically consistent plan to fulfill your stewardship responsibilities goes a long way to keeping you on course during the difficult times.

Accommodating your fears

And there will be difficult times. Hopefully you’re realistic, and understand that investing will occasionally expose you to tumultuous storms and cross-currents that roil the global markets.

Developing a plan, having boundaries, taking a long-term view — it all works pretty well until we enter one of those storms. Then, many investors, despite their good intentions about staying the course, are gradually worn down by the consistently negative news and falling stock prices. They remember past bear markets and how their portfolios were damaged. They imagine a recurrence, or even worse. Eventually, they make an emotional decision — time to bail out.

They experience short-term relief, but usually it comes with a long-term cost. That’s because they typically have no strategy for deciding when to invest in stocks again. The news is always bad at the beginning of new bull markets, and it won’t appear “safe” to reinvest until stocks have climbed 20%-30%-40% from their lows. More often than not, that means buying back in with prices at a higher level than when they sold.

How to prepare your portfolio for a bear market

In this article, we’re reiterating a set of SMI guidelines to help you through the stormy times. Readers familiar with SMI’s philosophy know that we don’t normally encourage the type of market-timing activity described above. Most investors who attempt it, in a scramble for what they perceive as a safe haven, do not come out ahead as a result. That’s a fact, verified by study after study.

However, it’s also a fact that as much as we might preach “don’t bail out, stay the course,” a sizable number among our readership will have great difficulty doing that. Even veteran SMI readers have admitted that, contrary to their long-term plan, they sold everything during the very difficult second half of the 2008-2009 bear market. They felt relief at escaping the down market, but had no specific strategy for getting back in, and watched from the sidelines as stocks rallied 75% from their 2009 lows in a 12-month period. What can we do to help these folks do a better job of navigating these occasional economic storms?

We’re going to suggest an objective, structured timing approach for reducing risk during those periods when further market weakness may be forthcoming. The remainder of this article will explain these guidelines.

Not every SMI member should follow these guidelines

First, it’s crucial that we define exactly who these guidelines are for. SMI has taken significant steps over the past three years to equip our members for the next bear market. The introduction of our Dynamic Asset Allocation strategy (DAA), which contains within its normal operating structure the ability to get completely out of stocks during a bear market was a significant step in this direction. The further emphasis we’ve placed on strategic ways to combine SMI’s investing strategies, such as the 50-40-10 approach that invests half of a portfolio in DAA, 40% in Fund Upgrading, and 10% in Sector Rotation, has been a focused effort to position SMI members in “all weather” portfolios that can withstand the rigors of a bear market without requiring any type of tinkering or adjustment. If you’re using a 50-40-10 approach, or have at least half of your portfolio in DAA, bonds, or some combination of the two, there’s likely no need for you to consider the guidelines that follow. Your portfolio simply doesn’t need it — it’s likely sufficiently conservative already.

Or, depending on your investing temperament — more on this shortly — this article is likely not applicable to your situation if you are more than 10 years away from retirement (or otherwise needing to withdraw money from your portfolio). With that more distant horizon, you have plenty of time to ride out any short-term storms and likely recover any losses before you would start any withdrawals.

The group that’s left, then, is comprised primarily of those either in retirement, or within 10 years or so of it. We’ll also throw in anyone else who knows they are likely to take counterproductive action to their portfolio in the absence of some sort of structured “safety valve” such as we’re about to describe. We’d rather see this last group just sit tight and do nothing, but better that they follow these guidelines than attempt to wing it on their own.

SMI’s “Bear Alert” Indicator

Given the defensive properties of DAA, the focus of any actions we take to reduce risk in our portfolios is going to be on the riskier strategies, specifically Fund Upgrading (you can also reduce your Sector Rotation allocation as you see fit). But first we need to deal with the question of when to take these defensive actions. We feel strongly that trying to anticipate market declines, as many are trying to do today, is an exercise in futility. Most investors do a horrible job of predicting what the market will do next, and studies of the rates of return of those who try to anticipate market moves confirm just how much damage this type of amateur market timing does to their long-term performance.

As with SMI’s other mechanical strategies, we think the much better approach is to follow the market trend and let actual market action tell us when it’s time to take action. This obviously means we’ll never call the exact top — by definition, this type of “trend following” means incurring some losses before taking defensive action. But it helps avoid the numerous false signals that those who invest based on predictions about the future inevitably endure.

This brings us to SMI’s “Bear Alert” indicator. The Bear Alert attempts to measure the likelihood that a new bear market has begun. The goal is to distinguish between a sell-off that is within the bounds of normal bull-market activity, and one that is likely to turn into a full-fledged bear market. It’s been accurate 10 out of the 13 times it has sounded in the past 50 years, and on those 10 occasions the market has proceeded to fall an average of nearly 20% further after the Bear Alert sounded.

The Bear Alert is triggered whenever the weekly S&P 500 reading (i.e., Friday’s closing price) falls 15% below the most recent market high. It’s an easy calculation, and it needs to be made only once a week. Now that the market has weakened enough to put the Bear Alert within striking distance, we will be writing about it more frequently. SMI members can sign up for automatic email alerts so they never miss a signal. (This can be done from within the "My Account" section by clicking on the "Email Subscriptions" tab at the top of the screen.)

Making incremental changes to your portfolio

We’ve established that the Bear Alert is not officially a part of any of SMI’s strategies, but is offered as a concession to those who are strongly inclined to take defensive action in their portfolio. In that event, our advice is to wait and let SMI’s Bear Alert dictate the timing. Trying to avoid run-of-the-mill stock market corrections is almost always a losing effort — they’re simply too common to avoid. Jumping in and out of the market usually leads to substantial long-term damage to your portfolio

When the Bear Alert triggers, the focus of our actions will be limited to the Upgrading portion of the portfolio. It’s important to know your investing temperament at this point. We offer a quiz in the “Start Here” section of the SMI website to help SMI members determine this. You may want to revisit the quiz and reaffirm in your mind which of the personalities most closely matches your approach to investing.

It’s with this framework in mind that the guidelines for an orderly approach to risk reduction were developed. They assume you have arranged your current portfolio allocation in a manner consistent with your risk temperament and season of life. By this, we mean your “normal” allocation matches those shown in our “seasons of life” matrix, a version of which is shown in the nearby table.

On the right-hand side of the table, under the heading “Bear Mkt Allocation,” we show an alternate, temporary way of dividing your portfolio between stocks and bonds. When SMI’s “Bear Alert” indicator sounds a warning (which doesn’t mean we’re in a bear market but that the chances have increased that one could be on the way soon), the alternate portfolio allocation, with a smaller commitment to stock funds, could be put into place.

This alternate allocation would remain in effect until SMI’s “All Clear” indicator signals that the worst (probably) is over. Then you would return to your normal long-term allocation. (We will write more about the All-Clear indicator later, once we actually have a bear market to recover from.)

Don’t overdo a good thing

A warning to those inclined to think: “Well, if reducing my stock allocation in part is good, why not go all the way and eliminate it altogether? Wouldn’t I improve my returns even more?” The surprising answer is, “Probably not.”

That’s because there are two phases to the plan — initially a reduction of risk, later a resumption of risk. The reduction phase is emotionally easy. When the market has been falling, it’s natural to want to move to a position of somewhat greater safety. Selling some of your stock holdings has a “feel good” quality to it.

The resumption of risk, on the other hand, is emotionally challenging. By the time SMI’s All Clear signal sounds, the market has typically risen about 20% from the lows but there will still be a lot of uncertainty and fear in the air. It usually seems like a risky time to add to your stock allocation. It’s quite likely you’ll be reluctant to do this. Imagine two investors with “Explorer” temperaments who each have a normal allocation of 70% stocks. When the Bear Alert signal came, one of them followed the plan and moved to a 40% stock position. The other decided “more is better” and sold all of their stock holdings. Now, to return to their normal positions, one needs to move their stock allocation from 40% to 70%. The other needs to move from 0% to 70%. Which do you think is going to have a harder time acting?

Remember, our primary goal in devising this plan isn’t to improve your long-term results. Rather, it is to provide a “release valve” that will help you overcome the fear that grips many investors when they go through a difficult bear market. Hopefully knowing you have a well-thought-out mechanism in your plan to reduce bear-market danger will help you resist the impulse to take defensive actions whenever stocks fall and investors get fearful. Use these guidelines as designed (in moderation), and you will likely experience greater peace during bear markets.