How retirees can survive a bear market

This study’s findings are surprising because they run counter to what investors for years have been taught about how we should react to volatility. We’ve been told that our emotions are our worst enemies when it comes to making portfolio decisions. That in turn means that, even though our guts tell us to run for cover when stock market volatility spikes, we should instead be maintaining or even increasing our equity exposure.

It turns out that our guts were right. The stock market historically has turned in above-average performance when the CBOE’s Volatility Index
VIX,
+17.36%
has been low, not high. This is illustrated in the accompanying chart, which plots the S&P 500’s
SPX,
-3.37%
monthly average total return as a function of the VIX’s monthly average. Notice that the highest average return was produced in the 25% of months with the lowest VIX levels, and that this average declines steadily as VIX levels rise.

I wrote about this strategy two years ago for Retirement Weekly. I am revisiting it now because its performance during this year’s bear market is a good illustration of its benefits. While it called for being close to fully invested at the end of last year, it quickly reduced its recommended equity exposure as market volatility spiked upward earlier this year. So far this year its average equity exposure has been more than 30 percent lower than the market’s.

Using VIX as a market timing tool

Moreira and Muir do not recommend using the VIX as an all-or-nothing signal to trigger moving from 100% in the market to 100% in cash. Instead, they suggest using it to gradually increase or decrease your equity exposure. In various emails over the last couple of years, they have provided me with a few simple rules for how this might work in practice:

1. Pick a target or default equity allocation. For example, if you’re otherwise fully invested in stocks, your target or default equity allocation would be 100%.

2. Determine a middle-of-the-road VIX level that will correspond with your target allocation. This baseline level is what you will be using to determine your equity exposure. If the VIX is higher than your baseline, your equity exposure will be below your default level—and vice versa.

3. To determine your precise equity exposure level for each month, multiply your target allocation by the ratio of your VIX baseline to the closing VIX level of the immediately preceding month.

To illustrate, let’s assume your target equity allocation is 100%, and the middle-of-the-road VIX level that corresponds to that target is the historical median—which currently is 17.71. Given that the VIX at the end of July was 21.33, your equity allocation in August would be 83.0%. And assuming the VIX closes August at where it stood as this column goes to press, your allocation for September would be slightly lower at 81.3%.

While this approach typically doesn’t call for huge exposure changes from month to month, it does lead to wide swings in equity exposure over time. In the case of my hypothetical illustration, the equity exposure level since 1990 varied from a low of 28.3% to a high of 174.9% (on margin, in other words).

I backtested this approach to 1990, which is how far back data for the VIX are available. I credited the 90-day T-bill rate to the noncash portion of my hypothetical portfolios, while debiting margin interest cost when the model called for being more than 100% invested.

You might wonder what’s so impressive about a strategy that didn’t make more money than the S&P 500. The answer lies in the strategy’s lower risk—14% lower, as measured by the standard deviation of monthly returns. As a result, the strategy’s Sharpe ratio (a measure of risk-adjusted performance) is markedly higher than that of the S&P 500.

Essentially equaling the market’s return with lower risk is a big deal, because that lower risk increases the likelihood that investors will actually stick with their financial plan through thick and thin. The S&P 500’s considerable volatility in bear markets is one of the big reasons why investors give up on their plans during bear markets—almost always to their long-term detriment.

The table doesn’t show how the strategy has done so far this year. But it has lost significantly less than the market, losing 7.8% through Aug. 25, when this column is going to press. Though a loss is never welcome, it’s a lot smaller and more tolerable than the losses incurred by the overall market.

As the saying goes on Wall Street, he who wins during a bear market is he who loses the least.

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Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected].