The higher the AI ​​bull market goes, the more nervous I get. That's why I thought about whether I had adequately protected myself in the event of an accident.
This is not because I am predicting an impending market crisis. Not at all. Despite warnings from prominent bank executives and hedge fund managers that the stock market has risen too high, I believe the craze for artificial intelligence – and stock wealth – is likely to keep the market trending higher for a while longer.
Fabulous wealth is generated on the stock market. Nvidia achieved a total market valuation of $5 trillion, at least briefly. Microsoft has passed the $4 trillion mark. Apple too. The numbers are so large that it is difficult to understand them.
They reflect share prices that seem exaggerated to me. Sooner or later the market will experience a serious downturn. Stock markets always do that. President Trump's deliberately disruptive policies have only increased this risk.
As a long-term, low-cost index fund investor who has benefited from decades of uptrends in the stock market, I'm not giving up on stocks. I decided a long time ago to stick with the market and that decision has paid off.
But I consider how much is at stake for me—how much in stocks and how much in bonds—and consider what impact it would have on my overall investments if stocks fell as sharply as they have in the four U.S. bear markets since the early 2000s.
The question is whether I am sufficiently diversified and hold enough bonds and other assets after the sharp rise in stock prices.
It may seem perverse to worry about potential market losses at a time of notable gains. Because if you have owned an S&P 500 index fund since the current bull market began on October 12, 2022, you have doubled your money.
But terrible stock market declines happen with alarming regularity. Diversification, or owning different assets, has helped alleviate problems in the past. When the stock market is better than expected, it's worth remembering how bad things could suddenly get.
The dark side
Bear markets are usually understood to mean price declines of at least 20 percent from top to bottom. There were a lot of them: 15 for the S&P 500 and its predecessors, starting with the crash of 1929, according to a tally by Howard Silverblatt, a senior index analyst for S&P Dow Jones Indices.
These were all painful episodes. In terms of total losses, the bear market triggered by the 2007/2008 financial crisis was the worst since 2000. The S&P 500 fell 56.8 percent from top to bottom. According to Silverblatt, this horrific period began on October 9, 2007 and lasted 17 months before ending on March 9, 2009.
What made it worse was that it came just five years after another, longer-lasting bear market – the dot-com crash of the early 2000s. This decline lasted 30.5 months, from March 24, 2000 to October 9, 2002. The S&P 500 fell 49.1 percent from top to bottom.
Between the two crashes, there was a bull market in which the S&P 500 index rose 101.5 percent. That's a huge number, except for a basic math problem that affects all bear markets. When stocks fall 50 percent – as they almost did during the dot-com bear market – they must rise 100 percent to get back to where they started. (If you started with $100 and lost half of it, you had to double your remaining $50 to get back to $100.)
Investors who held on to the S&P 500 index after the dot-com crash were still doing poorly a decade later. The numbers are sobering. Those unlucky enough to have bought S&P 500 index funds at the peak in March 2000 were sitting on a loss of 8.3 percent a decade later, including dividends, according to calculations I did on FactSet.
This didn't happen in isolation. These two market downturns also resulted in two recessions. Entire industries were affected. Millions of people lost their jobs. Those who retired or were already retired suffered serious setbacks.
Could something as bad or worse happen now? Yes, of course. And far worse things have happened to the U.S. stock market if you look back to the Great Depression of the 1920s and 1930s. Using inflation-adjusted data, Nobel Prize-winning economist Robert Shiller found that it took 29 years to recover from the 1929 stock market crash.
Such stories become commonplace during severe downturns. Focusing on them could put you off the stock market entirely, but I think that would also be a mistake.
pain and Gain
Holding on to the stock market for the long term is the secret of investing, hidden in secret. As I pointed out this summer, the S&P 500 returned 38,881.17 percent over 60 years. That means $1,000 invested 60 years ago would have been worth about $390,000 at the end of June — as long as you stuck with it, even through terrible downturns.
The US market has been good over many shorter but still long periods. Let's go back to the beginning of 2000. Despite four bear markets – in 2020 and 2022, in addition to the two in the first decade of the century – the S&P 500 returned 8.1 percent annually over that period, including dividends – for a total gain of 652 percent.
In contrast, bond investments look tenuous. The Bloomberg US Aggregate Bond Index, a benchmark for investment-grade bonds, returned just 4.1 percent on an annual basis, for a total gain of 181 percent.
So if you didn't care about these periods of stock declines, you would have been better off just owning the stock index fund – or, if you had the foresight to pick the best stock on the market, just bet on Nvidia. This stock's gains since the start of 2000 make almost all the others seem insignificant: 34.9 percent on an annual basis, or 230,607 percent cumulatively.
Still, it would have taken the stronger stomach I possessed to survive a naked investment without any protection, either in the broader stock market or in a stock like Nvidia. For example, Nvidia lost more than 60 percent of its value within eleven months starting November 11, 2021.
That's why I'm sticking with bonds and other less exciting investments like bank deposits and money market funds and am taking a closer look at them now.
Looking for security
In most, but not all, bear markets, investment grade bonds have been a blessing.
For example, in the decade beginning March 24, 2000, which included two bear markets, the S&P 500 fell more than 8 percent, but the Vanguard Total Bond Index fund returned 79.8 percent, or 6 percent on an annualized basis. It was wonderful to own bonds back then.
However, bonds did not always provide such protection. Take the bear market in 2022. The value of bonds fell along with that of stocks. This is because inflation rose sharply and interest rates rose. (Interest rates, or yields, move in the opposite direction to bond prices.) Currently, thanks in part to Mr. Trump's tariffs, inflation is still at uncomfortably high levels, leaving the outlook for bonds uncertain. With the government shutdown underway, public data insufficient to provide clarity, national debt rising, and a beleaguered Federal Reserve under pressure from the Trump administration, it is possible that inflation will rise sharply again.
As I pointed out last week, Treasury bills (those with maturities of one year or less) and money market funds have excelled in recent years. Although their yield has fallen below 4 percent, money market funds still generate an annual return of more than 3 percent, which could rise further if inflation picks up and interest rates rise. In such circumstances, although government inflation-protected bonds would be havens, core bond funds would struggle to generate positive returns.
On the other hand, the remarkably resilient economy could falter, lowering interest rates, increasing bond yields and hurting money market funds and Treasury rates. For greater margins of safety in a severe downturn, bank savings accounts covered by the Federal Deposit Insurance Corporation would be preferable to uninsured money market funds.
I don't know where the economy is going or how long the stock market will rise before the next big reversal occurs. The old 60/40 portfolio – with 60 percent stocks and 40 percent high-quality bonds – is a traditional compromise between risk and security. I include some short-term funds in this 40% fixed income allocation. And I invest globally because the U.S. stock market's stellar performance may not last.
If you take the risk of investing in stocks – especially during a stock market rally that seems to be characterized by excessive enthusiasm – it is crucial to be prepared for setbacks, even severe ones.
On a stock chart over many decades, bear markets looked like small blips on a long path upward. But try to figure out what you can handle before the artificial intelligence frenzy in the stock market abruptly ends.