How to Endure Bear Markets

On the year, the S&P 500 is down 8.7%, which doesn't look half bad compared to the 23.6% shellacking we've taken here in the Rule Maker Port. Some of us are experiencing our first bear market. If nothing else, however, this year's market drubbing provides a good lesson in Foolish expectations. We should all expect to lose money in certain years. A look back at history confirms that years like this one are par the course.

But before we look at any history, ask yourself and really think about this question: What are my expectations as an investor? To help you gauge your real feelings on that issue, see whether you identify at all with this anecdote from today's Wall Street Journal:

"At the start of 2000, [Mary Lynn Hodges, a homemaker from Berlin, N.J.] put money in the Janus Global Technology Fund, which had just completed its first year in business with a gain of 212%, one of the greatest debuts in mutual-fund history. 'I bought in January, watched it soar and bragged to my husband about the wonderful investment I made for us,' Ms. Hodges said of the fund, which jumped more than 25% in the first two months of the year, but is down 28.6% through Wednesday. 'Now I am moaning about how much we have lost. He is taking it better and keeps telling me it is for the long term,' she says of her husband."

It's imperative that we remember the only reason stocks offer the potential for superior long-term returns is because they carry HIGH short-term risk. Yes, HIGH. This year will serve us all as a vivid reminder that short-term savings -- any monies needed in the next three years or less -- should not be in stocks. If you're saving up for house remodeling in the spring, or a big winter vacation to the Caribbean, or for your high school junior's college education -- put it in a certificate of deposit or a money market account.

Don't be a fool. Stocks are a wonderful savings vehicle, but only over long periods of time.

We usually refer to a five-year period as being "long-term," but even five years doesn't leave you entirely in the clear. Since 1802, there was one five-year span in which stocks returned negative 11% annually. That would've turned an original $10,000 into $5,584. Taking a wider view of all the five-year periods since 1802, we find that stocks underperform Treasury bills about one-fourth of the time.

So, Foolish expectation numero uno is that stocks can and will do ANYTHING over the short-term. Parabolic moonshots and death-defying dives are both possible.

We also need to have realistic long-term expectations for what the stock market can do with our money. Bear in mind that the past two decades -- during which the S&P 500 posted an annualized return of 18% -- do not represent the norm! Thanks largely to those two great decades of wealth creation, the entire 20th century averaged an annual return of 10.4%. When you think about all of the past century's wars, economic recessions, and political uncertainty, an average return of 10.4% is actually pretty encouraging.

But even within that 10.4% figure, we need to realize all the volatility built into that average. In the 10 decades of the 20th century, only one produced an average annualized return within a single percentage point of the 10.4% overall average:

1900s          9.96%
1910s          4.20%
1920s         14.95%
1930s         -0.63%
1940s          8.72%
1950s         19.28%
1960s          7.78%
1970s          5.82%
1980s         17.57%
1990s         18.17%
20th Century  10.40%