This article is reprinted by permission from NerdWallet.
A bear market is defined by a broad market index falling by 20% or more from a recent high. And as of market close Monday, the S&P 500 index officially hit bear market territory. It’s down more than 21% year-to-date.
So what does that mean for you? Bear markets can be stressful for investors of all stripes. But they frequently affect active stock pickers — people who invest mostly in individual stocks — differently than passive index fund investors.
Here’s what economic experts say about the current sell-off, and what it could mean for you.
What’s behind this bear market?
“Discretionary spending is gone,” Daniel McKeever, an assistant professor at the Binghamton University School of Management, said in an email interview.
U.S. consumers “are dipping into savings, if their savings aren’t gone already. And eventually, that’s not going to sustain stock market growth,” he said.
McKeever, a lecturer on investments and derivatives markets, said high inflation is leading many people to spend less, which means less money in companies’ pockets. And that leads to the stock market’s current woes.
“Without some kind of meaningful relief from the increase in gas and grocery prices … people simply don’t have money to spend,” he said.
The consumer price index has increased 8.6% over the last 12 months, while the S&P 500 has fallen 11.9% over the same period.
These numbers are the same for all investors, regardless of their investing strategy — but they may translate into different returns and volatility levels for active and passive investors.
What does this bear market mean for active and passive investors?
Active investors, or individual stock pickers, try to beat the market. Passive investors often try to mirror the market.
Those active investors “can be better or worse off during a bear market, depending on their stock picks,” said Eric Nelson, a certified financial planner and founder of Independence Wealth, a New Jersey-based registered investment advisor.
Stock picking tends to be higher risk (and potentially higher reward) than passive investing; stock pickers can theoretically beat the market by picking stocks that outperform their indexes. But they also can (and usually do) end up with worse returns than the market by picking stocks that underperform their indexes.
Passive index fund investors will probably see less volatility because they will not have individual stock risk, Nelson said in an email interview.
That’s because when you invest in an index fund, you’re investing in a basket of companies that aims to mirror a stock market index, so if one company goes out of business because of, say, a bear market, there are still others to buoy your portfolio.
McKeever said that financial advisers who manage portfolios actively sometimes bill themselves as superior to passive investors during downturns, but research suggests that isn’t the case.
“Active management does no better than passive management during crisis periods, just like it does no better than passive management over any long horizon,” McKeever said.
The latest Quantitative Analysis of Investor Behavior, or QAIB, study from financial services market research firm Dalbar Inc. found that the average equity investor — as opposed to a passive investor in the index — earned more than 10% less than the S&P 500 in 2021 — the third-largest underperformance ever recorded in the study’s 36-year history.
How should you respond to the bear market?
Don’t panic, most financial advisers say. If you’re an investor — not a day trader — you’re in it for the long haul, and you know there will be highs and lows. The average stock market return is 10% per year, and yes, sometimes, like in 2022, it’s lower, and sometimes it’s higher. It’s a good rule of thumb to stay invested and resist the urge to pull out of the market on down days like these.
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Some investors recommend devoting no more than 10% of a portfolio to individual stocks, and keeping the other 90% in a diversified mix of low-cost index funds.
If you do this, and you’re using dollar-cost averaging, you might take a temporary hit, but most likely, if you have a longer-time horizon, your portfolio has time to recover.
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Sam Taube writes for NerdWallet. Email: firstname.lastname@example.org. Twitter: @https://twitter.com/samuel_taube.