When a bear market doesn't matter

By Morningstar

In recent months one phrase has dominated the financial media: bear market.

At first, the question simply was whether we might be headed for a bear market, defined as a 20% decline from the market's peak. Then, as major stock indexes tumbled near that level, the issue became more precise: At what moment will we hit bear market territory? When the thresholds were passed, the concern shifted to other matters, such as how long bear markets typically last and how much further stocks typically fall after entering bear territory.

All this was interesting and attention-getting, in its way. But all in all, rather than getting wrapped up in these issues, you'd be better off looking at your own portfolio and, if you're content with its structure, going to the beach. Market declines are important, but official labels are not.

The convenience of the definition

As noted above, a bear market is defined as a decline of 20% or more in a stock index. Who made this rule? Probably the same person who decided that a recession occurs if, and only if, a country's gross domestic product declines for two consecutive quarters. Not one quarter. Or one and a half. Two.

Kidding aside, it's understandable why certain people, such as academics and other professional market researchers, would require a standard definition. Without it, the history of the stock market could be described only as a series of ups and downs; researchers wouldn't even be able to agree on how many downs had occurred. Only by defining some cutoff points and assigning a few labels can one take a meaningful look at market history.

The everyday noneffect

Those standards, however, have no relevance for ordinary investors. For that reason, the media attention to the formal definitions is at best a distraction. At worst, it can be harmful. It's a distraction because investors shouldn't base their actions on whether the stock market's decline has passed a certain milestone.

If you're worried about oil prices, the housing downturn and the fall in the dollar, for example, those issues have the same degree of importance whether the Dow Jones Industrial Average ($INDU) has declined 18% (a so-called correction) or 21% (a bear market).

The same applies to changes in personal circumstance. If your concern over your job security has heightened recently, inducing you to keep more money in cash in case you need it quickly, the exact level of the stock market shouldn't affect that decision.

Further, the bear market fixation implies that a downturn is conclusively more damaging if the index is in bear market territory than if it isn't. But that's questionable.

On one particular day this summer, the Standard & Poor's 500 Index ($INX) closed at a level that put it exactly 19.99% below its high. At that point, we were not in a bear market.

If the index had recovered but then spent the next three years hovering in a range between, say, minus 15% and minus 19.99%, and then rose decisively, officially no bear market would have occurred. I'm not sure, though, that most investors would have agreed, especially those whose stocks or funds had plunged much further than that.

The potential harm

Unfortunately, bear market fixation can cause harm, rather than just act as a distraction, because the tone implies that once we enter a bear market, conditions have changed for the worse. Articles tell us how long and deep past bear markets have been. The implication is that we should batten down the hatches and behave more cautiously.

In reality, an official bear market could last just a day or a month; perhaps the market's been weak for a while and 20% is as far as it's going to fall on this occasion. But articles about "how to handle a bear market" give the impression that once the 20% barrier has been pierced, a door closes behind us and that we're going to be in the soup for a while.

That can be a self-fulfilling prophecy. If people believe a bear market, once begun, must continue for a while -- and likely get worse, as the numerous published charts show past bear markets have done -- they may sell stocks, thus pushing down prices further.

Don't fear the bear

The fact is, it's possible that the more profitable course would be to buy stocks once we enter a bear market, not sell them. That's not assured; stocks could fall much further. But even contemplating buying is tough to do when every magazine cover or TV segment features a snarling grizzly. (Why don't such menacing images appear at the top of the market? That would be much more helpful.)

In short, a market decline is a serious matter, and it's worthwhile to learn about the issues that caused it. However, it's not worth your time to wonder whether the drop in a stock market index has passed this or that threshold. Leave that to the academics, the brokerage-house researchers and the people who draw big, scary animals to populate the covers of magazines at a newsstand near you.

This article was reported and written by Gregg Wolper for Morningstar.