Financial Consult: Go Ahead, Embrace the Bear

“For those properly prepared in advance, a bear market in stocks is not a calamity but an opportunity”
-John Templeton, Mutual Fund Pioneer 

At work most of my colleagues would probably call me a pessimist. Rising malpractice premiums, flat reimbursements, increasing workload…are there any positive trends in emergency medicine? Similarly, rising oil prices and inflation, rising unemployment, snail-paced economic growth…are there any reasons to invest in stocks? Most economists think we’ve entered the next bear market, which is most commonly defined as a 20% or more drop in stock prices from the previous peak. In October 2007 the S&P 500 (a proxy of the US stock market) reached its peak of about 1565, but just nine months later in July 2008, it sat at 1214, a 22% drop. Think you can handle the heat? Your newbie $100,000 portfolio crumbled to $78,000 and your $2 million retirement portfolio just demoted you to millionaire status. While the skies are covered with doom-and-gloom clouds, I’ve managed to find a few good reasons which will soothe the bear’s bite.

Reason #1: Buy cheap stocks

I love Wal-Mart. I actually get a thrill from buying everything from groceries to jeans for some dirt cheap prices. When it comes to investing, however, it seems counterintuitive to buy when others are selling. “Buy low, sell high” seems so easy to say but so emotionally wrong to do. After all there is a cliché in investing which says that the best time to buy stocks is when there is “blood on the streets.” We spend days or weeks searching for the best deal on our plasma TVs or our next gas-guzzling SUV. Should it be any different with our investments?

Consider this. Suppose you bought 20 shares of a stock for $50 per share for a total outlay of $1000. Then, nine months later the share price is $40, a 20% drop (bear market territory). Assuming you still believe in the merits of the investment, you can now purchase 25 shares for the same outlay. This technique, known as dollar cost averaging, assures you that the average price per share is lower than the average of the two prices because you have bought more shares at the lower price. More aggressive investors can use a technique called value averaging, whereby you buy enough shares to obtain a desired dollar amount. In the example above, to end with an investment amount of $2000, you would actually buy 30 shares of stock at $40. These techniques do not assure you of any gain or avoid losses because the stock price can go even lower, but at least it does assure you of reducing your average purchase price.

Reason #2: Reduce your taxes

If my portfolio is tanking, I may as well let Uncle Sam feel some of the pain. If you sell a stock for a loss, you can deduct up to $3,000 of the loss against your ordinary income. In other words this deduction directly reduces your active income from your emergency medicine practice. For those EPs in the 35% federal tax bracket, the $3,000 deduction equates to a tax savings of $1,050. Also, if your losses exceed $3,000 you can actually use the excess losses as deductions in future tax years indefinitely. While tax deductions imply stock losses, they also act as cushions to soften the blow.

Reason #3: Dump your losers

For some reason I just can’t let go of some investments. I become emotionally attached to them. A bear market really makes me question my initial reason for purchasing a particular stock. Did I buy the stock because I researched the company’s balance sheets, quarterly reports, and financial ratios? Or did I buy the stock because I overheard a surgeon in the doctor’s lounge boasting about how he made a 50% return in just two months? (If this happens, I suggest you ask him why he’s still working 70 hours a week).
Even if you bought a stock or other investment which has positive returns, bear markets are good times to sell those investments if they should not have been purchased in the first place. One strategy here is to sell these winning investments and avoid a taxable gain by offsetting those gains with losses from other losing investments.

Reason #4: Gauge your risk tolerance

For most investors risk tolerance is directly related to stock prices: in bull markets risk tolerance increases, and in bear markets risk tolerance plummets. In a previous article (March 2008) I discussed the three components of assessing your capacity to take risk. These include your willingness, ability, and need to take risk. One way to determine your willingness to take risk is to evaluate your emotional response to this year’s bear market. Did you sell and invest in cash, or did you load up on Delta Air Lines (down 48% through 8/1/08)? Another way is to quantify this risk by determining your maximum drawdown, which is the highest percentage loss you are willing to accept before selling an investment. Determining your maximum drawdown over one, three, and five year periods can help you build a more disciplined portfolio and stick with your investment strategy when the bear market comes out of hibernation.

Reason #5: Appreciate emergency medicine

While there are numerous challenges to practicing emergency medicine today, one thing is certain—the demand for emergency services and physicians is strong. In effect, our EM income is similar to a bond in the sense that there is low risk of default (unemployment). Our period of extended “unemployment” occurs right at the beginning of our careers (medical school and residency). If we consider our EM practice as a bond, we can actually take a bit more risk with our stock portfolio. While other professions and industries layoff workers, it seems nearly every week my mailbox is flooded with EM job opportunities across the US. My investment portfolio may be struggling, but my value in terms of human capital is stable. Ultimately bear markets make me realize some of the rewards of EM practice.

Setu Mazumdar, MD, practices emergency medicine in Atlanta, GA and is a member of the National Association of Personal Financial Advisors (NAPFA).