Week 31 Day 2: Bear Markets: The Price of Admission

Stocks earn more than bonds over time because stocks are riskier. The risk shows up as bear markets. If you could earn 10% per year guaranteed with no risk, everyone would pile in and bid the price up until the return dropped to match bonds (approximately 4-5%). Bear markets are what keep stock returns high -- they scare away the impatient, leaving the rewards for the patient.

Bear market statistics (S&P 500, 1945-2024): Frequency: approximately once every 5-6 years. Average decline: -33%. Average duration (peak to trough): approximately 12 months. Average recovery time (trough to prior peak): approximately 22 months. The full cycle (peak to trough to new peak): approximately 34 months. This means: if you invest for 30 years, you will likely experience 5-6 bear markets. Each one will feel terrible. Each one will tempt you to sell. Each one will be followed by a full recovery and new highs. Bear markets during your accumulation phase (when you are still working and investing): these are actually GOOD for you. You are buying shares at discounted prices. A 30% bear market means your $500/month buys 43% more shares than it did before the decline. Those extra shares compound for years. Bear markets near or during retirement: these are the dangerous kind because you are selling shares (to fund expenses) at low prices. This is sequence-of-returns risk, and it is mitigated by the bucket strategy, bond tent, and guardrails discussed in Week 25.

The equity risk premium -- the excess return stocks earn over risk-free bonds -- is fundamentally compensation for bearing the risk of large, temporary drawdowns. Mehra and Prescott (1985) originally noted the 'equity premium puzzle': the historical premium of approximately 6% is far larger than standard economic models predict given reasonable risk aversion parameters. Subsequent explanations include: (1) loss aversion (Benartzi and Thaler, 1995) -- investors weigh losses approximately 2x as heavily as gains, requiring a larger premium to hold stocks, (2) disaster risk (Barro, 2006) -- the small probability of catastrophic losses (wars, depressions) justifies a large premium even if those disasters rarely materialize, and (3) limited participation (Mankiw and Zeldes, 1991) -- many potential investors avoid stocks entirely due to risk aversion, reducing the marginal investor pool and maintaining a higher premium for those who do participate. The practical consequence: bear markets are the mechanism that maintains the equity premium. If bear markets ceased to occur, the equity premium would compress to near zero (as investors would bid up stock prices until expected returns matched bonds). The investor who accepts bear markets as the 'cost of admission' and remains invested captures the full premium. The investor who sells during bear markets forfeits the premium precisely when it is highest -- locking in losses and missing the subsequent recovery where the majority of the premium is realized.