What to Do When Stocks and Bonds Plunge

Don’t let inflation fears and market paroxysms paralyze you

a double exposed image shows a downtrend financial chart superimposed over a black and white photo background of an investor's hands on a computer keyboard

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Published May 05, 2022

"S&P 500 Books the Worst Start to a Year Since 1939" — Marketwatch

"Global Bonds Set For Worst Ever Month Before Burst of Rate Hikes" — Investment News

"Inflation Hits New 40-Year High" — NBC News

Recent financial headlines are somewhere between depressing and scary:

These headlines are depressing and scary because they portend a shrinking nest egg for all of us. Add the terrible situation in Ukraine to the collective anxiety, and it’s hard to know what to do. Our first instinct may be to sell our investments and take refuge in cash, but that’s the one asset class we know is virtually guaranteed to lose spending power to high inflation.

Before giving my thoughts on what to do now, let’s take a step back a couple of years, to early 2020. Between Feb. 19 and March 23, the total stock market, including large, midsized and small-company stocks, lost 35 percent in 33 days. COVID-19 brought dramatic change to our day-to-day lives and the global economy. Anxious investors struggled with how to respond. One person told me, “I know the phrase ‘This time is different’ is the costliest phrase in investing, but we’ve never had a pandemic before.” He sold all of his stocks. Another told me that stocks won’t recover until we get a COVID-19 cure.

As it turned out, stocks recovered quickly, and U.S. stocks gained more than 53 percent in total over 2020 and 2021, as measured by the Wilshire 5000, one of the broadest measures of the U.S. stock market. So, including dividends, $10,000 in U.S. stocks grew by more than $5,300. What worked during the March 2020 bear was selling bond funds, which held their value, and using the proceeds to buy enough shares of stock funds to return to your targeted allocation.

Why did stocks so quickly recover and surge in spite of two years of horrible news? My answer is, I don’t know. Markets constantly fool us, and that provides a key lesson: If we can’t even explain the past, just think of how difficult it is to predict the future.

All bears are not alike

By broad measures, we are not even in bear territory, which is generally defined as a 20 percent decline from recent highs. But assuming what happened in 2020 will happen now would also be a mistake. First, stocks recovered with lightning speed in 2020 in what was likely the shortest bear market in history. It’s unlikely this rare event will be repeated.

Second, bonds held their value in the 2020 bear, but both stocks and bonds are down through April. This year, through the end of April, a broad U.S. stock index fund is down by about 14 percent while a high-quality investment grade bond fund lost about 9.6 percent — rather than holding value, as they did in the last three bear markets. Inexplicably, despite what’s going on in Europe, international stocks bested U.S. stocks by 2 percentage points.

What I’m telling people to do now

Just as in March 2020, I have no clue how stocks and bonds will perform going forward. Certainly, the Fed will raise the key short-term fed funds rate, because they said they would. Yet that is already priced into both stocks and bonds, and the fed funds rate is merely the overnight rate. But, unlike 2020, there is less of a need to rebalance, since both stocks and bonds are down.

It may be reasonable to make a couple of changes on bonds. If intermediate and long-term interest rates continue to rise, bonds will continue to decline. Generally speaking, the longer the maturity of the bond, the larger the decline when interest rates rise. But it would also be a mistake to assume those intermediate and long-term rates will continue to increase. There are two ways to protect from the possibility of rising rates.

First, it really is now possible to earn high rates safely with I bonds. These are inflation-protected savings bonds, issued and guaranteed by the U.S. Treasury, and the previous link explains how they work and how to buy them. The current six-month rate for I bonds bought through October is 9.62 percent! That’s not a typo. The amounts that can be purchased are limited; you can also buy something similar known as Treasury Inflation-Protected Securities (TIPS), or TIPS Funds.

Another option is to buy a short-term Treasury note, which can be purchased through Treasury Direct or your brokerage firm. It’s an unusual time where a short-term Treasury note yields almost as much as a very long-term Treasury bond. As of May 2, 2022, a two-year Treasury note was yielding 2.74 percent — not much less than a 30-year yielding 3.07 percent. If interest rates do rise, the long-term bond will get hit far more than the short-term. Not only are Treasury notes yielding more than CDs, but the interest is also state tax-exempt. I think this is an option for part of a bond portfolio. Still, don’t abandon high-quality bond funds, since it’s quite possible rates will decline in scenarios such as a recession.

Unlike past stock plunges, this correction requires less courage. You don’t necessarily have to sell your bonds to buy more stocks, which I can attest is an unpleasant feeling, to say the least. And you can safely earn a much greater return on bonds while taking even less risk with I bonds, and a very good, safe return with shorter-term Treasury notes.

Investing is a (very) long game. I’ve found that people who constantly change their asset allocation targets typically chase past performance and underperform going forward. Sticking to a plan is simple but also very hard to do. Though I know it’s also a very hard thing to do, try to ignore the depressing news when it comes to investing. Remember, neither good times nor bad times last forever, and capitalism will survive.

Allan Roth is a practicing financial planner who has taught finance and behavioral finance at three universities and has written for national publications including The Wall Street Journal. Despite his many credentials (CFP, CPA, MBA), he remains confident that he can still keep investing simple.

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