Lessons from the "Lost" Decade: Surviving Bear Markets

(MoneyWatch)  With two bear markets in the past decade, we've certainly had opportunities to learn how to deal with them. But that doesn't make them any less painful. While it would be nice if we could find a way to avoid them (no one has), here are some things to consider the next time one arrives.

Active Managers Don't Protect Investors from Bear Markets
Active managers underperform during bear markets, just as they do in bull markets. The following is from S&P Indices Versus Active Funds Scorecard: "The belief that bear markets favor active management is a myth. A majority of active funds in eight of the nine domestic equity style boxes were outperformed by indices in the negative markets of 2008. The bear market of 2000 to 2002 showed similar outcomes."

As Nobel Prize winner William Sharpe explained in his paper, "The Arithmetic of Active Management": "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

The lesson is that you can't rely on active managers to protect you from bear markets.

Bear Markets Shorten Investment Horizons
As I mentioned in my lessons from 2009, bear markets can cause you to focus on the short term. It's important to remain focused on your investment goals. The rebounds from the bear markets of 2000-02 and 2008-09 should serve as a reminder that the world is never really as dark as it appears to be during a bear market.

Returns Are Not Earned Smoothly
For the decade from 2000 through 2009, the S&P 500 Index lost about 1 percent per year. But, not one single year produced a return within even 5 percent of the annualized return. And there were just three years, 2000 (-9.1 percent), 2005 (4.9 percent) and 2007 (5.5 percent) that produced returns within 10 percent of the annualized returns.

This isn't surprising, given the long-term data. As I have previously mentioned, years where returns are near their long-term averages are much scarcer than you'd think. The lesson is that the only way you can be sure to capture the returns markets provide is to be like deer hunters who know the importance of being there and using patient persistence. They're there when opportunity knocks.

Act Like a Postage Stamp
The two severe bear markets in the last decade demonstrated that it's not enough to just have a well-designed investment plan to be a successful investor. While the necessary condition for investment success is to have a plan that takes bear markets into account, the sufficient condition is to act like a postage stamp. The lowly postage stamp does one thing, but it does it exceedingly well. It sticks to its letter until it reaches its destination.

Your job is act like that postage stamp -- adhering to your plan, ignoring the noise of the market and disregarding the emotions caused by that noise -- until you reach your investment goal. If you can't do it yourself (and the evidence demonstrates that the vast majority can't), hire a financial advisor as the "enforcer" of your financial plan. A good advisor will not be impacted by the emotions bear markets cause.

Follow the series: Lessons from the "Lost" Decade

• Part one: Long-Term Investing and Needs Vs. Desires
• Part two: Rebalancing, Bonds and Correlations
• Part three: Viewing the Past and Future
• Part four: Surviving Bear Markets