February 20, 2015

Why There is Always the Potential for a Bear Market (and Why That’s a Good Thing)

A recent WSJ article explains why bear markets can occur at any time. The article emphasizes a common point made by FSIA with its clients, that the higher expected return from equities is compensation for the additional risk of holding stocks.

It is exactly because bear markets can occur at any time that stocks have a higher expected return than bonds.

A simple line of reasoning explains why this must be the case. Assume a world where stocks and high quality bonds were equally risky but stocks had a higher expected return than bonds. What would happen in this world? All bond positions would be sold (lowering bond prices) and the proceeds would be placed into stocks (raising stock prices). This process would continue (instantaneously in an efficient market) until the expected return on stocks and bonds were equal. Thus the equally risky securities would have equal expected returns.

The higher expected return from stocks is a result of, not in spite of, the potential for stock prices to get hammered. Let’s hear it for bear markets!!!