Journal of Financial Planning: June 2025
NOTE: Please be aware that the audio version, created with Amazon Polly, may contain mispronunciations.
Ryan Zabrowski, CFP®, is director of arbitrage and senior portfolio manager at Krilogy (www.krilogy.com).
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Whatever your perception of the market is this morning, if you learned the chances of it suffering a 30 percent decline are triple the normal probability, what would you do for your client portfolios?
My guess is you would advise them to pull some money out of the market. But what should they do with that withdrawal?
Maybe move the proceeds into a money market fund and wait for a recovery? When will that happen? Because you don’t know for certain, you’re apt to be late advising your clients to get back into the market, missing the big days of the early rebound. Meanwhile, inflation starts to erode their capital’s future purchasing power, and they lose the rate of return needed to meet their long-term goals.
More to the point, even if the probability of a bear market is lower, it’s a mistake to sell profitable businesses (stocks) that could earn a bushel of money. It’s usually better to sell any lower-quality bonds in the portfolio as they are correlated to stock market declines. If the economy enters a recession, lower quality bonds have a higher probability of default.
The other investment to sell in an impending bear market would be alternatives that require a positive market, such as long-only or long-biased strategies.
So, what investments should you suggest your clients move their money into?
In a bear market, investors should own non-correlated or, ideally, negatively correlated assets. Correlation refers to a measure of how investments move relative to one another. Assets that move in the same direction at the same time are considered positively correlated, whereas non-correlated assets tend to move independently to larger fluctuations in the stock market. Negatively correlated assets tend to move in the opposite direction of one another.
You could take that money and move it into investments that have historically performed well during pernicious bear markets: alternative investments like market neutral strategies, managed futures, and gold.
Market Neutral Strategies
One of the elements of successful investing in a down market is a market neutral strategy. When the stock market is retreating, investors should have a portion of their portfolio in market neutral strategies—investment returns that are uncorrelated with stock or bond market returns—so they can profit from market movements in either direction: up or down.
Typically, a market neutral strategy is achieved by holding both long positions in one security and short positions in another. The securities involved are usually stocks, but can also be bonds, real estate, or other investments. Roughly half the money is assigned to each side of the ledger—long and short.
The profitability of a market neutral strategy relies primarily with the skill of the portfolio manager or the quantitative strategy. Assuming investors have half their money long in stocks and the other half short in stocks, whether the market goes up or down 20 percent doesn’t really affect the strategy. What does have an impact on the strategy is the skill set of the manager or the strategy itself, and whether the stocks bought long outperform the market and those bought short underperform the market. When that occurs, investors can squeeze out some impressive profits in a bear market. In our algorithm, if the probability of a bear market is high, we automatically increase the allocation to market neutral strategies.
The profitability of the market neutral strategy is not determined by market direction. It is, rather, largely dependent upon the ability of the manager executing the strategy to make savvy investment decisions, regardless of what is going on in the markets, or the world for that matter.
Investors often confuse market neutral strategies with long/short strategies, which currently represent 26 percent of the world’s hedge funds.1 While long/short also seeks to take advantage of undervaluation or overvaluation by taking long and short stock exposures, the main difference is that the long/short manager has the latitude to change the 50/50 long/short ratio of the fund.
Investors in long/short strategies tend to assume they are protected from bear markets, but that’s not always the case. I’ve seen instances where a long/short manager has drifted to a 70 percent long (30 percent short) position, which exposes the fund that is supposed to be market neutral to significant market risk. The key here is to maintain the 50/50 position.
Strategies where the manager can tactically determine how much of a portfolio should be long or short do not provide adequate protection in a major market downturn. They are popular because managers (and most investors) know that over longer periods, stock prices rise, so having a larger percentage of long positions attempts to take advantage of that fact. I don’t want that in my portfolio, however. When our algorithm indicates a high probability of a bear market, I don’t want long/short—especially a fund that’s drifted to a stronger long position; I want true market neutral for protection in a bear market.
Managed Futures
A futures contract is an agreement to exchange a security at a specific price on a specific future date. Unlike option contracts, futures contract buyers are usually required to execute their contracts and accept delivery of the underlying asset.
Managed futures are unique, one of the few investments that can not only make profits, but extremely large profits in a bear market. One reason why is because managed futures profit on persistence or trends, that is, when investments trend in an identifiable direction. For example, if the price of oil continues to rise, managed futures can make a lot of money. They can also earn substantial amounts of money on declining commodity prices. They are non-directional. They are not dependent on whether the price of the underlying asset will go up or down but rather the anticipated volatility of the asset. This is another reason why managed futures are an important component of surviving—or profiting—from a bear market.
Managed futures can be categorized as a trend-following strategy, executed by investing in the financial markets’ current trends or, as industry insiders refer to it, persistence. There exists mathematically proven persistence in how capital markets work. As trends develop and certain investments begin to outperform, the movement acts like a magnet for capital because most investors are followers (the herding bias) who want in on what appear to be successful investments. As this persistence continues, it attracts ever-greater amounts of fresh capital, pushing the trend further forward.
The caveat with managed futures is that you don’t want to own them unless there is a clear and persistent direction in the market. If the market is moving up and down a few percent month to month, seesawing back and forth but not exhibiting any significant trend, a managed futures strategy has a high probability of experiencing a negative return. This type of non-persistent market is not a threat for pure stock investors, but managed futures in a sideways-trending market can be a disaster.
The success of a managed future strategy, much like that of a market neutral strategy, is contingent upon the skill of the fund manager to identify trends versus short-term market movements.
In a bear market when stock prices are plummeting, investors get nervous. Many outright panic. This can trigger a discernible negative trend. When this occurs, investors want their money invested in the best skill-based, non-directional strategy. The only way for most investors to make money in the stock market is if the stocks go up. In a managed futures strategy, however, money can be non-directional. So even if stocks, bonds, and commodities are all falling in price, investors could theoretically make a lot of money with a managed futures fund invested in nothing but short positions across the board.
Fundamentally, managed futures are non-correlated assets that tend to make a lot of money when things get exceptionally directional and volatile, the same environment that can be exceedingly hazardous for pure stock investors.
Gold
Even though no country is on the gold standard today, many still hold large reserves of gold as a hedge against economic calamity. Gold prices and recessions historically have maintained an inverse relationship. When the economy weakens, gold prices tend to increase as investors seek safe-haven assets. During the last three recessions of 2020, 2007, and 2001, the price of gold increased while the value of the S&P 500 decreased. Gold prices tend to mimic inflation, and as paper money loses value, gold becomes a more valuable asset, providing a hedge against inflation.
Another reason the value of gold tends to rise during market downturns or outlier economic events is that gold is liquid. It can be converted into cash. The same cannot be said for the sale of equities, however. Obviously, some stocks are more liquid than others by the nature of their popularity or other factors. But during a crisis or even periods of severe market volatility, there may not be any willing buyers for a particular stock. Companies fail.
When the probability of a bear market is high, ideally, investors should own assets that are negatively correlated to the U.S. stock market. It’s how savvy investors can make money in a down market. Gold is one of the investments that facilitates that. But to clarify, the gold I refer to here is bullion, not gold stocks, because gold stocks can be correlated to the overall market. If an equity fire sale occurs, particularly among the indices, and there are gold company stocks—such as Newmont, Barrick, or Agnico Eagle—held in those indices, they’re going to be decimated along with everything else in the index.
While the inverse relationship between gold and the U.S. dollar isn’t as precise as it used to be under the gold standard, the relationship remains intact because a falling dollar increases the value of other countries’ currencies, which in turn increases the demand for uncorrelated assets like gold. It also increases the price.
Summary
I believe the optimal method for making money in a capitalist economy is to own good businesses (equities). In a bullish market, I want more of the total portfolio allocation directed toward these businesses and less toward alternative investments. When the probability of a bear market rises, I want to incrementally increase investment in alternative strategies and reduce investment in low-quality bonds, alternatives that require a positive market—such as long-only or long-biased strategies, and other investments correlated to the stock market.
The extraordinary beauty of this tactical allocation strategy is that it is all predetermined. As new data is entered into the model and the probability of a market decline changes, everything dynamically updates, precisely because the allocations are predetermined. This allows moving with the necessary swiftness in responding to changing data.
There is no need for harried response to the latest market data. The appropriate responses have already been built into the model, having been calculated under calm conditions, not the chaotic atmosphere that spawns knee-jerk reactions to market fluctuations.
One of the common errors that devastates portfolios is the propensity for investors to overreact to market volatility. This same type of herd behavior can be observed in investment committees as well, especially in larger committees where the group tends to acquiesce to the highest level of leadership, or worse, to the loudest speaker.
When the economic atmosphere experiences turbulence, like an inexperienced pilot, investors lose their nerve, become disoriented, and end up crashing their portfolio.
When the markets plunge, they lack the confidence to take enough risk. When a bull market emerges, they pivot and take too much risk. On the other hand, when the proper asset allocation and investment decisions for each market environment have been predetermined under objective, dispassionate conditions, investors gain the courage to ignore the noise all around them.
Here’s an important statistic to remember: 78 percent of the stock market’s best days occur during a bear market or during the first two months of a bull market. Missing the best 10 best days over the past 30 years would have reduced your returns by half. Missing the best 30 days would have reduced your returns by 83 percent. Fully half of the best days of the S&P 500 Index during this millennium occurred during a bear market. Another one-third of the market’s best days took place during the first two months of a bull market, before the investment herd had any indication a bull market had begun.2
The principle of remaining invested is ingrained in a long-term approach. I advocate the concept, but not to the extent that I become a passive victim of market oscillations. I want my model to be a tad early reacting to bear market fluctuations leading to peaks and troughs. Being just a little late can cause the portfolio to miss the market’s best days—the ones that occur during the first two months of a recovery. By catching the eighth or ninth inning of a bear market, I’m going to absorb some short-term losses, but that’s the acceptable trade-off for being at bat when the best days happen and knocking one out of the park.
Endnotes
- Wolinsky, Jacob. 2022, March 31. “Long/Short Equity Popular Among Fund Managers but Not Investors.” Forbes. www.forbes.com/sites/jacobwolinsky/2022/03/31/long-short-equity-popular-among-fund-managers-but-not-investors/.
- JMG Financial Group. 2022, May. “The Risk of Being Out of the Market.” www.jmgfinancial.com/the-risk-of-being-out-of-the-market/.