Understanding market cycles can be very beneficial for investors.
Recognizing where the market currently is in a cycle can allow an investor to properly overweight/underweight their portfolio to different types of stocks. Historically it has been shown that doing this even in very simplistic ways, such as adjusting weightings of large cap vs. small cap stocks can create significant long-term outperformance.
While using knowledge of market cycles to hopefully get excess returns is exciting and great, I believe it is a distant 2nd in the “list of reasons to understand market cycles.”
The most important reason for understanding market cycles is it gives an investor the mentality and peace of mind resulting in “Do No Harm.”
A continual theme that I hit on is that the stock market over long-term periods has provided investors with the greatest combination of returns and liquidity compared to other asset classes. However, individual investor returns have historically tended to significantly underperform stocks. The majority of that investor underperformance is attributed to “investor mistakes.”
An understanding of market cycles can help an investor avoid mistakes, and potentially get better than market returns.
Now that we know why understanding market cycles are important, let’s take a gander at some basics.
Bull Market: A general increase in stock market prices over a period of time. (Sidenote: many people are completely unaware that we have been living in the midst of a bull market since 2009, see more on that http://wswartzco.tumblr.com/post/140771393717/bust-out-the-bubbly )
Bear Market: A general decline in stock market prices over a period of time. Officially it is considered a bear market when the decline is of more than 20%. A typical bear market occurs over a 12-18 month period.
Market Correction: A reverse movement, usually negative, of at least 10% in a stock, bond, commodity or index. Corrections are generally temporary price declines interrupting an uptrend. A correction has a shorter duration than a bear market.
Personally the duration, behavior, and perceived cause play a much larger role in differentiating between bear markets and corrections. If the markets tanks 23% and V bottoms back up to previous levels within a ~6 month time frame, I would likely consider it a correction (depending on perceived cause) even though the decline was more than 20%.
Similarly if the markets were to average a decline of 1-2% over several months, and then have a sharp decline which finally bottomed at -18% over a 10 month period start to bottom, I would be very tempted to consider it a mini-bear market despite not hitting the -20% mark.
