A few readers have suggested I’ve been taking this stock market downturn pretty badly.
To which I’ve made some overly defensive replies.
Such as that it proved right to be gloomy. The growth sell-off was a canary in the coal mine. There has been a regime change. Bonds have cratered like none of us have ever seen. And the US stock market just ended its worst first-half for 50 years.
And to turn the tables, some of those apparently more upbeat readers appear to me to have been going through several stages of grief – or at least self-rationalisation – without being aware of it.
“My portfolio is barely down” followed a couple of months later by “Okay, we’re down a bit but that’s normal” then “Right, we’re down a lot but everyone knew everything was expensive and so it’s healthy” to “Of course we’re down but I don’t care because there’s nothing I can do about it.”
Which is all fair enough. Whatever keeps you investing! And changing your emotional response to the market’s rises and falls will likely be more profitable than remixing your portfolio whenever your mood swings.
Still, I think it’s helpful if we pay attention to our shifting thinking, rather than waking up every day presuming that – like yesterday, last week, and last month too – we’re omnipotent.
As Richard Feynman said: “The first principle is that you must not fool yourself and you are the easiest person to fool.”
Bona fide hustler making my name
Continuing in that spirit, perhaps readers who’ve detected more angst than usual in my missives have a point, too.
Sometimes our thinking is revealed in our writing before we fully understand ourselves.
I remember that when blogger @ermine flagged up my talk of turbulence in December 2021, it prompted me to re-read my own article for myself.
And on reflection I probably have been gloomier in 2022 than I’ve allowed myself to dwell on.
My net worth more than halved for a few months in the 2008 bear market. Yet on Monevator I was writing about how I was selling my possessions to buy more shares.
In 2022 I’m down by far less, and yet I’ve been posting videos of Tom Hardy beating rivals to a pulp.
Did I change, or did the market?
Money money money, must be funny
Two posts this week helped me admit to Mr Market that it’s not him it’s me that has a problem.
What feels great is being on an upward path. That’s when dopamine takes over. That’s when you can extrapolate it and assume it goes on forever, and compare yourself to where you were before, and feel like nothing can stop you.
When that path declines – even if it happens when you have a level of wealth you couldn’t fathom a few years ago – the whole sensation shatters.
Somewhere along the line my fun game of trying to beat the market grew to dwarf whatever aims I had when I started investing.
Change is fine, if it’s in the direction you want. I’m not even saying this change isn’t right for me. But I need to reflect on it more, if I’m to avoid mixing up my goalposts.
I shouldn’t feel excessively down on a six-month view, when I’m doing fine on a five-year one.
The other timely article came from Lawrence Yeo, who asked:
If your basic necessities are covered, how is it that money can still trigger a survival instinct that is indistinguishable from that biological fear?
Why is it that having enough money doesn’t just alleviate this fear, but often has the opposite effect of strengthening it?
It’s true – I’m far more attuned to my net worth than when my savings amounted to just a couple of months rent.
Even after this year’s steep losses I could pay off my mortgage tomorrow and still be financially independent. Certainly by my old Bohemian standards.
Yet I’ve grown more cautious in my portfolio – and apparently I sound grumpier on the Internet.
Perhaps I am more afraid than I realize?
When you’ve got nothing you’ve got nothing to lose
I’d summarize the difference between the 2008 crash and this one for me as:
In 2008 I was a moderate high-earner, just into the higher-rate tax bracket, but saving and investing well beyond what you’d expect for my means. I’d been investing for half-a-dozen years, and writing about it for a couple. My portfolio was shellacked but I had no debt or obligations and I planned for many years of investing ahead.
In 2022 I am earning much less. But as the year started my portfolio was well beyond ‘my number’ and I was in no rush to boost my income. I’d been investing for two decades and writing about it for 15. My portfolio is down but nothing like as bad as in 2008. I’m many times wealthier now – but I also have a big mortgage, and 15 fewer years to recover from setbacks.
There are clearly big financial shifts to unpick here.
I’ve got more to lose in gross money terms, most obviously. I’ve fewer years left to compound my portfolio, and less fresh income to help. I’m vulnerable to a bad sequence of returns. My mortgage adds risk.
All factors we’ve covered on Monevator, I know. But even a nodding acquaintance with the personal lives of famous novelists, say, tells us self-knowledge is not a vaccination against human frailty.
Knowing the symptoms is only part of the battle. You have to turn the lens on yourself.
Alongside this rise and fall of my net worth, there’s also the change in my self-identity.
In 2008 I was only a few years into investing. I made my living in an unrelated field. I was just starting to become a fully active investor.
Today I should feel far more secure – except that my identity is now wrapped up in my investing lifestyle. That makes it as vulnerable to portfolio shocks as if investing were my full-time job.
In the years since 2008 investing became an obsession. One that delivered financial independence many decades sooner than if I’d kept my savings in a current account.
But it is also an obsession that has co-mingled my sense of self – and perhaps of achievement and even ‘worth’ – with the short-term, random, and always febrile stock market.
No wonder if I feel more discombobulated that I used to when the market falls.
Turn and face the strain
The truth is I’ve seemingly become a walking, blogging hunk of loss aversion made flesh.
Indeed it’s sort of humbling how universal and ever-tricky this psychological stuff is.
I often see such blind spots in readers, too (just to put you guys back on the hook…)
For instance, someone will explain they can’t retire early until they hit £5m, because of a long list of logical reasons that starkly contrast with the fact that my co-blogger did it on barely a tenth as much.
Of course he FIRE-ed into different circumstances, and with different expectations.
But equally, you strongly suspect that the £5m would-be retiree will soon need £10m.
Or consider my married friends who are from Mars and Venus when talking about their finances.
One of them has never acknowledged how childhood shaped their money beliefs.
The other can’t see how now having made more money than they once expected to earn over several lifetimes should prompt them to revisit their stance on spending.
There are also the regular Monevator commentators who predict one market outcome adamantly, and then a few months later apparently always thought the opposite.
They change their past to fit the now-likely future.
I don’t believe they are deceitful – except in as much as Feynman says we all fool ourselves.
But it does seem a bit like a way to feel good about yourself, whatever happens.
I’m certainly not immune to fooling myself, but I can (sometimes!) admit when I was wrong – and I’m also happy to feel bad now and then.
I’m sure those are more profitable mental habits to cultivate in the long run.
That ain’t workin’, that’s the way you do it
On the same score, it seems 2022 is telling me too to do a wetware update on my mental attitudes, if I want to better enjoy the pros and cons of where investing has got me.
Unlike many people who needed to change a spend-y mindset to get to financial security, I was born with the saving gene. For me that was easy.
But I don’t think I know how to feel secure about having financial assets, now I’ve got them.
The market will bounce back one day. So will my portfolio. Despite a gloomier 2022, my belief in that hasn’t changed.
And of course for the majority of readers still in accumulation mode, cheaper shares and bonds due to a correction are the windfall they’ve always been.
But this is the first bear market when I’ve been as mindful of wealth preservation as of growth (which I’ve certainly not given up on…)
I made some changes, such as in February when I ring-fenced a big chunk of my net worth from the quixotic pursuit of outperformance – by moving it into a duller and lower-volatility basket that I track separately from my unitized return-seeking portfolio.
But I may need to do more to disentangle my money in my mind.
Do you? Let us know below, and have a great weekend!
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We’re often told that investing is risky. But it’s during wild bear markets that the risk truly hits home.
Most people can handle a 5% temporary loss when the market drops. That’s easily reversed.
Even 10% down only smarts a little.
But when the market caves 20%, our belief in solid ground can start to crumble.
We realise the bottom could be a long way down. The risk feels real.
Like most of our fears though, the way to confront a bear market is not to let it gnaw at us with ill-defined menace. The risk is best handled by understanding it, knowing your options, and having confidence that this too will pass.
What is a bear market?
A bear market occurs when the closing price has fallen 20% from its previous peak in an investable market. This bear market definition can apply to a global market, a single stock market, any other asset class (such as property, bonds, gold, or other commodities), or even a single share.
The US Securities and Exchange Commission (SEC) adds the caveat that the decline should last two months or more to qualify as a bear market.
The media is more likely to raise the alarm though as soon as an important market dips 20%. Typically a 20%-plus decline in a broad market index like the US S&P 500 is taken as proof that a bear market is underway.
That drop is interpreted as a bellwether indicator that investor confidence is evaporating and the contagion could spread. Even though another market such as the FTSE All-Share (or your own portfolio) may not yet be in bear market territory.
And history and experience tells us that bear markets can plunge much further than 20%. The UK’s worst bear market in the past century was the -73% stock market crash of 1972-74.
Investing in a bear market is scary because it can herald large-scale wealth destruction which lasts for years or even decades. That can trigger panic-selling, which has damned the financial future of many a poor soul.
It’s critical you keep your head during the bleakest hours because most bears are relatively short-lived and transform back to bulls in time – as we’ll see below.
What a bear market looks like
We can see the impact crater gouged by the Global Financial Crisis in the chart below. It was one of the severest bear markets of the modern era.
The chart highlights all the main features of a bear market:
The previous market peak
The slide into bear market territory beyond 20% down
Source: justETF:Performance of iShares MSCI World ETF October 2007 – March 2010. Dividends reinvested.
The MSCI World ETF entered bear market territory on 6 October 2008. Like many bear markets the fall unfolded over months. The MSCI World had dropped 24% from its previous peak a year earlier at this point.
Along the way, bear market rallies offered hope the worst was over. However they fizzled out on 6 November 2008 and 5 January 2009.
And just when you thought it was safe to go back into the stock market, equities plummeted to new lows.
The market bottomed out at -38% on 6 March 2009. Almost 17 months after the fall began.
Technically this trough marked the end of the bear market. That’s because prices subsequently recovered to a new peak.
But you couldn’t have known this was the turning point at the time. The news was dreadful, day upon day.
We had no guarantee this was the floor – as this contemporaneous dispatch from The Investor reveals.
The market climbed back out of the hole and reached breakeven on 9 March 2010. (In nominal terms. Breakeven after inflation took until 2013).
The exact date of recovery is weirdly difficult to pin down. Living, breathing investors like us should incorporate dividends, inflation, and investment costs into our results before celebrating the vanquishing of a bear market.
Are bear markets normal?
Yes, bear markets are relatively common. Vanguard’s data for the UK stock market shows it in bear territory for 11.3 years out of 76, or 15% of the time from 1945 to 2021.
The graph below shows the MSCI World stock index suffered six bear markets from 1970 to 2020. We added another bear market due to the pandemic in 2020.
And we’re in bear market territory now once you factor in inflation.
Source: BRWM: Today’s market falls in the context of history. Data from Morningstar.
Unfortunately, bear markets are the price of admission when you seek the opportunity to earn big gains from equities.
These periodic declines are shocks to the system that drive investors to demand an equity premium for bearing the risk of holding volatile assets.
If these risks didn’t materialise occasionally, then everyone would put most of their money in shares. And in such a world, equities would eventually earn a miserable, cash-like return.1
Crashes are as necessary as forest fires. They’re fearsome at the time but they set the stage for future growth.
The grey line in the graph above shows the growth of £1 invested in equities over the years. The risk is clearly worth taking.
But those setbacks marked by those deep orange slashes are why investing is a long-term game.
Does a bear market mean recession?
A bear market does not necessarily mean a recession. According to fund manager Invesco’s paper on S&P 500 bear markets, only eight out of 17 bear markets coincided with a recession from 1927 through 2021.
In other words, the majority of bear markets do not signal a recession.
Moreover, recessions often rear their ugly heads without the stock market tail-spinning into despair.
A bear market occurred in only three of the last 14 US recessions, and positive equity returns accompanied seven of those recessions.
Bear v bull market
Bull markets follow bear markets because the widely accepted definition of a bull market is a 20% investment price rise that follows a previous 20%-plus drop.
A bull market is ended by the next sustained 20% or more drop. So bears punctuate bulls like extinction events in the fossil record.
A Vanguard analysis reveals the frequency of bear markets from 1980-2020 (MSCI World index):
The numbers show that the bear market vs bull market contest is a walkover for the good guys.
Bulls dominate bears over the long-term both in duration and performance.
World bear v bull market score (% of total years)
Bears: 13%
Bulls: 87%
This pattern holds for the UK stock market 1945-2020:
Source: Vanguard: Bull and bear markets over time (UK).
UK bear v bull market score (% of total years)
Bears: 15%
Bulls: 85%
And it holds in the US, too (1900-2020):
Source: Vanguard: Bull and bear markets over time (US).
US bear v bull market score (% of total years)
Bears: 17%
Bulls: 83%
Another definition of a bull market requires prices to rise to new all-time highs on top of the minimum 20% lift from the last bear market low.
Variable definitions – plus data discrepancies – explain why you’ll see different dates and results for bear and bull markets, depending on the source.
Global bear markets may even disappear from the record altogether when viewed from the vantage point of the UK, as opposed to the US.
For example, US investors have experienced nine global bear markets since 1980, according to Vanguard:
But four of those bear markets vanished when Vanguard analysed the same data in pounds:
Some of the discrepancy is likely explained by the fact that the pound tends to fall during a crisis while the dollar appreciates.
Hence UK investors with a global portfolio dominated by US shares may be spared the worst. Sterling’s weakness is like a buoyancy aid for our US assets, providing a partial hedge against the state of the UK economy.
In this scenario, currency risk works for you. And it’s one reason why UK investors may be better off not currency hedging their equities.
Incidentally, on the Richter scale of fear, a market ‘correction’ is one level down from a bear market.
As uneasy is to alarmed, a market correction occurs when investment prices drop 10% to 19.99% from previous highs.
How long do bear markets last?
Bear markets last 30.2 months on average for global equities between 1900 and 2019. The shortest bear market was three months (1987’s Black Monday) and the longest was eight years and 11 months (World War One plus its prelude and aftermath).
The average bear market lasts 25 months, if we remove the WW1 and 1987 outliers. That’s according to Global Financial Data’s table of global bear markets:
Why is the two and a half year average length of a global bear market so much worse than Vanguard’s 1.1 years quoted for the UK and US earlier in the article?
Well, the UK data series we cited began after both World Wars while the US emerged from each conflagration comparatively unscathed. In fact, both country’s stock markets had a good 20th Century, relative to rivals.
Interestingly, contemporary bear markets look no less severe than the sepia-toned crises of pre-1950.
Investors were down -50% and -55% in the depths of the Dotcom bust and the Global Financial Crisis. That exceeded the losses inflicted on stock markets during the World Wars.
Every bear market from the Vietnam War onwards was over inside two years – except the 30-month implosion of the Dotcom bubble.
The WW2 bear markets and the 1929 crash lingered around three years, but they are easily outdone in the annals of misery by WW1’s ghastly nine-year slump.
However, we can never really know how long a bear market will last.
So it’s best to gain as many historical perspectives as we can.
If we really want a scare, then Global Financial Data says the longest US bear market in history lasted 51 years from 1792 to 1843.
The longest UK bear market in history stretched an agonising 42 years from 1720 to 1762. Back then the London Stock Exchange fell 74% when the South Sea Bubble burst.
Perhaps we shouldn’t take ancient bear market history very seriously? The losses inflicted on bewigged speculators trading in 18th Century coffee shops may not seem to hold many lessons in the age of central bank bazookas.
Not so fast! The fallout from Japan’s 1989 asset bubble bursting inflicted not one but three lost decades on that nation’s market.
Some argue the ensuing bear market is still ongoing. But I estimate the main Japanese stock market index recovered to breakeven in February 2021 – adjusted for inflation and dividends.2
Either way, this piece explains why most Japanese investors weren’t as badly mauled as a multi-decade bear rampage implies. In the real-world, investors don’t invest everything they’ve got in a single market on the very eve of disaster.
The length of time you can spend trapped in the jaws of a bear suggests that special investing tactics are required.
Indeed, I came across a popular investment site that offered:
Switching to defensive stocks
Buying inverse ETFs that bet on market declines
Taking a punt on put options
Do not do any of this.
Defensive stocks (as represented by low volatility ETFs) are so much bear bait. They still go down in a stock market crash. They perhaps won’t fall as hard as high-risk growth equities, but defensive stocks are not a safe haven like bonds and gold can be.
Inverse or short ETFs are designed for professional investors betting on a market fall on a particular day. They can seriously backfire on passive investors who mistakenly think these products are useful during a prolonged bear attack. Read this piece on how short ETFs work if you want to know why.
Put options are also like playing with fire. Puts can be profitable if you’re a semi-pro investor. But you must also be prepared to take large losses when your positions blow up. If that’s you, then I’ll hand you over to Early Retirement Now’s material on the topic.
A passive investor learning this stuff in a bear market? It’s like walking into a casino half drunk.
Even fund professionals can’t outmanoeuvre a bear market.
So forget market timing or switching up your asset allocation.
Instead, there are some straightforward but powerful techniques that can help you through a bear market…
How to invest during a bear market
Bear market recovery times make for depressing reading. But the goods news is your bounce-back will be fast-forwarded by something you’re probably already doing: pound cost averaging.
Regularly investing over time shortened the UK’s longest bear market recovery time by a third.
Do nothing and the UK market took nine years to breakeven after the 1972-74 stock market crash. (In real, inflation-adjusted terms, including dividends).
However, the recovery period was reduced to six years by pound cost averaging.
Let’s consider an investor back in the 1970s who made regular annual contributions worth 3% of the portfolio’s initial value. For example, suppose £3 was contributed per year into a £100 portfolio, as depicted in the table below. (That’s equivalent to £3,000 in a £100,000 portfolio.)
As the table illustrates, their portfolio was back in the black by 1980 instead of 1983 with just these relatively modest contributions:
Contributions were invested at the end of each year and were not inflation-adjusted.
Most people who invest regularly do so monthly, but I don’t have access to UK monthly returns.
Nonetheless, this annual approximation shows the power of pound cost averaging to accelerate a recovery as the market rises again.
Six years is still a long time to wait, but it’s substantially better than nine.
And you could have sped up the recovery by investing even more. This is especially feasible when you’re a relatively young investor, and your portfolio hasn’t yet grown to a size where new contributions won’t move the dial to the same extent.
Automatic remedial action
Pound cost averaging is underestimated because it enables us to do the right thing without agonising over it.
Much as we know we should buy stocks on sale, for instance, it’s much easier to say than do. It takes courage to fling money at a bear market when you feel like you’ve been punched in the gut.
But automating the process with a monthly regular contribution enables you to buy the dips and lower the average price of your holdings.
Those cheap shares ultimately reward you with tidy profits as prices rebound.
As the bear v bull market charts above remind us, equities typically bounce back like Rocky shaking off bad-dude haymakers.
That’s the recurring theme of this post amid the talk of savage bears. The market comes back eventually.
Be confident that global capitalism will engineer the recovery. Stick to your plan.
Threshold rebalancing
Switching to threshold rebalancing instead of annual rebalancing is another sound move when investing in a bear market.
At its simplest, you’ll trade asset classes that have drifted 10-20% off from your pre-set asset allocations.
It’s a classic ‘sell high, buy low’ technique that requires you to ship out some of your best performers and scoop up armfuls of the stuff nobody wants.
Emotionally it’s hard to do. You must steel yourself to take action, like a football manager cashing in on an aging club stalwart whose contract is up.
Threshold rebalancing is more sensitive to market movements, where annual rebalancing may see you miss out on a golden buying opportunity if the bear market is short-lived.
The downside of threshold rebalancing is it requires you to look at your portfolio more often during the bloodbath. That is a bad idea for some.
Why investing in a bear market makes sense
The other thing you need do is stay invested. As The Investor counselled in his bear markets strategies piece written during the Global Financial Crisis:
What too many investors do instead, is get out of the market completely after the bear market strikes.
Like this, they crystallise their losses, and risk missing out on the stock market’s recovery.
Don’t beat yourself up if the market continues to fall.
Going back to the savagery of that 1972-74 UK crash, the market only entered bear territory in August 1973 – some 15 months after the first sign of trouble.
It was 40% down by the end of Jan 1974.
Many people would assume that made UK equities a screaming buy.
But they’d have to endure another 21% dive in March.
Then watch as a further 37% was lopped off from May to September.
All before a final, jarring, minus-18% elevator-drop floored them in December 1974.
The real return loss from top to tail was -73%.
You’d need the forebearance of a saint to take that on the chin.
But your faith would have been rewarded. As Global Financial Data explains:
The best time to have invested in (UK) stocks over the past 327 years was at the end of 1974 when the index rose 127.68% [99.6% real return] during the next year. This was also the best time to invest for the next ten years (30.64% annual return), 20 years (20.39% annual return) and 30 years (16.11% annual return).
Keep calm and carry on investing
Finally, one last reason to believe that falling stock markets can be a good thing.
One of the best-known market valuation metrics is the Shiller CAPE3:
High Shiller CAPE ratios are correlated with low future returns (over the next ten to 15 years) because investors overpay for company profits
High valuations (red bars) portend low future returns
Low valuations (green bars) auger higher returns
Bear markets slash stock prices, which lowers the Shiller Cape. That in turn suggests better times lie ahead.
It’s far from guaranteed but there is a relationship between undervalued markets and future returns.
That is one of the reasons stock prices bounce back so forcefully in many of the charts we’ve seen today.
Just as overbought, euphoric markets light the fuse on their own destruction, oversold, depressed markets sow the seeds of recovery in the loamy ashes of defeat.
You don’t need fancy market timing moves in a bear market. What you need is resilience, patience, and belief.
Take it steady,
The Accumulator
What would happen is the price of suddenly-safe equities would be bid up until their expected returns were just a little bit above what you get from cash and bonds. After this one-time gain, equity returns would be mediocre going forward. But luckily for we poor strivers, that’s probably never going to happen. [↩]
I can’t really believe the chart below from JP Morgan that circulated around financial Twitter this week.
US investors are seemingly so prone to woefully bad attempts to time markets and other kinds of trading mishaps that they earned just 2.9% annualized over the past two decades:
Reading the small print reveals the graph is based on data from Dalbar Inc. That company’s work has foregrounded the so-called ‘behaviour gap’ for many years.
The behaviour gap describes how poor active choices by investors – such as trying to time markets, or to chase hot investments – means that most ultimately receive a far lower return than the broad asset class data implies.
The Dalbar study is also subject to regular debunking. I’m not even sure where we are with that right now. But JP Morgan apparently believes Dalbar is still credible.
Or maybe JP Morgan has something to sell. Unfortunately I don’t have access to more than that screenshot, so I can’t give you its official pitch. Perhaps it’s taken from Why You Should Entrust All Your Money To Us To Manage, Mortals, where it’s presented as evidence? Who knows.
What I can say is that if the average investor in conventional assets has really seen just a 2.9% return over 20 years, then you can see why so many of them chased rock JPGs and SPACs and GameStop at the height of the bull market in 2021.
I mean, what did they have to lose?
(Okay, apparently 2.9% a year.)
We can do better guys! Read my co-blogger The Accumulator and do as he does. Or do as our model passive portfolio does. That’s nearly 9% a year over the past 11 years, with just a handful of trades per quarter.
Or invest in an all-in-one index fund. Anything but 2.9% a year.
Franz Kafka’s classic The Metamorphosis sees the central character go to bed a man and wake up as a giant cockroach. Does your mortgage risk a similar transformation in 2022?
It sounds heretical. For more a decade it’s been almost daft not to run a cheap mortgage.
Barely there interest rates made for affordable repayments. Ever-higher house prices and stock markets meant owning additional assets was more rewarding than repaying your debt.
But now rates are rising. Stock markets have crashed, and house price growth is slowing.
Recession talk is in the air.
Sky-high inflation has driven a regime change. Low inflation and near-zero interest rates have given way to expectations of dearer money in the future.
The shift has already hit the highly-rated growth stocks inside your index fund.
But mortgage risk is a bigger existential threat to most of us than wobbly stock markets.
Why your mortgage matters so much
With about eight months to go until my own five-year fixed-rate mortgage ends, I’ve been thinking a lot about mortgage risk.
Having a big mortgage on your personal balance sheet dramatically shifts your financial posture.
And as a lifelong debt-hater, I’ve found having a mortgage challenging at times.
As I told friends who’ve been mortgaged since their mid-20s – and who couldn’t see what I was fussing about – getting a mortgage changes everything.
Because it’s really hard to go bankrupt if you’re not in debt. You can usually alter your circumstances to match your income. The Micawber Principle holds.
Sure we can all imagine scenarios where everything goes to zero and you end up under Waterloo Bridge. But absent debt, a lot must go wrong for that to happen.
With a mortgage though, things are different.
For starters it’s not hard to find yourself with a negative net worth. First-time buyers who put all their savings into buying a home with a 95% mortgage, for instance, are in the red if their house falls in value by just 5%. (Dragging them into ‘negative equity’.)
Bigger price falls might offset ISA and pension savings, putting even wealthier mortgage holders in the hole.
This certainly isn’t fatal in itself.
Crucially, a mortgage is not marked-to-market. As long as you make your monthly payments you’re okay – even if house price falls mean that you’re technically underwater until markets recover.
But what if you lose your job, or there’s some other financial disaster?
You could then struggle to keep up with your mortgage. Especially if mortgage costs are rising as rates climb.
In the worst case the bank repossesses and sells your home, you’re on your uppers – and you still owe the lender whatever is left of your mortgage debt.
Around 345,000 homes were repossessed in the 1990s housing crash.
That’s the nightmare scenario.
Assess your mortgage risk before it matters
I don’t want to overdo this. Interest rates are still low by historical standards, and employment high. And there’s no indication of a house price crash, except for property’s perennial expensiveness.
I’ve plenty of assets, despite recent market falls. And I can handle a fair few rate rises.
I expect the majority of mortgaged Monevator readers feel the same.
You’ll typically have emergency funds, other investments, jobs, and you didn’t overstretch to buy.
However we’re all at different stages of our financial lives. Some readers will be edge cases.
Besides, the time to prepare is always before a disaster actually strikes.
Complacency kills!
A checklist to assess your mortgage risk
My interest-only mortgage is backed by my investment portfolio, rather than my salary.
And I didn’t get my mortgage like you got your mortgage. (It was personally arranged).
The whole shebang is very different. This means I must consider several moving parts – and different risks – when evaluating my mortgage-related moves.
You can probably do a simpler sanity check. But I think you’ll still find food for thought below.
Let’s get started.
Re-financing risk: what happens when your mortgage deal expires?
For most readers, this is a formality. Provided you’ve still got your job and nothing dramatic has changed, it should be straightforward to get a new mortgage deal when your current one ends.
Remember your initial mortgage was for 25 years or more. Any fixed-rate term of, say, five years was a special bonus period. Your contract runs for 25 years.
This is a good thing. It means that if you don’t get a new special deal, you should just go on to your lender’s standard variable rate (SVR). So you won’t suddenly need to repay your mortgage.
But what you probably want is a new bonus offer.
Let’s say you come to the end of your fixed-rate period. You should probably look to remortgage on a new fix, or some other kind of special rate. This will likely be cheaper than staying on the SVR.
Your best deal could be with your current bank, or with a different lender.
Sitting pretty with higher equity
Your status as a borrower has probably improved since your last mortgage deal.
UK house prices have been rising. This likely applies to your home, too.
You’ve probably also paid off some of the mortgage balance, alongside the interest.
Combined, this means you should have more equity in your home. (Equity is what’s left when you subtract your outstanding mortgage from the value of your property).
More equity usually means access to better rates.
Before, you might have been in the 90% loan-to-value (LTV) mortgage category. But perhaps your greater equity now puts you in the 80% bracket.
Banks will offer you a lower rate compared to somebody with less equity. Lending you money has become less risky. There is a bigger equity buffer against house price falls.
Remember this is mostly helpful for the bank because it protects its loan if it has to repossess your property and sell it. You obviously don’t want it to come to that!
When remortgaging you’ll also have a – hopefully clean – history of making mortgage payments. No longer are you a highly-stretched young schmuck without a track record. That will further increase your appeal to lenders, compared to when you were a first-time buyer.
So shop around.
Look out for early repayment charges: Most mortgage deals come with a penalty charge for early repayment of the mortgage for as long as the deal lasts. For instance I faced a 5% penalty in the first year of my five-year term, falling to 1% in the final year. However I can pay off 20% of my outstanding balance every year without penalty. Check your small print. Also: sometimes it may be worth paying a penalty charge to secure a new mortgage deal at a lower rate.
What if you lost your job?
If there’s been a big change in your circumstances you may struggle to get a new mortgage deal.
That’s because you could be asked to prove your income and other details such as credit card debt as part of your application for the new deal, just like when you first got your mortgage.
However at worst you should just revert to continuing on your lender’s standard variable rate. Your home ownership is not immediately at threat.
The downside is the SVR is probably costlier than with a deal. You’re also exposed to future mortgage rate rises (or cuts).
I’d suggest it’s nearly always better to lock in a fixed-rate mortgage when you can.
Even if you believe interest rates might not rise much more – or fall – the security of having a fixed schedule of mortgage payments is valuable.
Not sure where you’ll stand when your current deal ends? Give your bank a call so you can prepare.
Repayment risk: keeping up as mortgage rates rise
However you refinance your mortgage, you may well have to pay more each month because mortgage rates have been rising.
To state the obvious: higher mortgage rates mean higher monthly payments.
Can you cope? Do your sums to see if you should already be rethinking your budget.
I covered stress testing your mortgage against rates rise in my last post.
Please read that if you haven’t. Rising rates is the biggest mortgage risk for most people.
Interestingly, however, there’s been a development since my last article.
The Bank of England has told lenders they no longer have to stress test borrowers to check they could afford to pay with much higher mortgage rates. The central bank believes that restrictions on loan sizes as a multiple of income will be sufficient to keep things under control.
Maybe so, but it seems a curious decision just when rates are rising. If the Bank wasn’t politically independent you’d smell a rat.
With respect to today’s topic though, this shift might make it easier for some people to remortgage in a pinch.
Remember, the high inflation ushering in higher rates is also eroding the real value of your outstanding mortgage. That is definitely a good thing.
However you need to keep up with your mortgage payments to benefit.
Repossession in an economic downturn is to be avoided at all costs.
House price crash risk
This brings me onto the potential for house prices to fall.
Lower house prices is not a direct mortgage risk.
Unlike with a margin loan with a stock broker, for instance, your bank does not constantly reassess the value of your home and demand more cash if your equity falls below a critical threshold.
That’s one reason why a mortgage a relative safe kind of personal debt.
The other reason – for you and your lender – is a mortgage is secured against your property.
This asset-backing is why you can borrow to buy a home at 3.5%, but credit card debt costs 25%.
But it’s also why falling house prices are a tangential mortgage risk.
If lower property prices mean the equity in your home has fallen when you remortgage, you could have to agree a more expensive deal.
And if you’re in negative equity you could end up stuck on your lender’s SVR.
Buy high, sell low
And what if you need to sell your home when house prices are down?
At best you’ll lose out because you have less equity in your home to get as cash after the mortgage is paid off.
At worst, your house sale won’t cover the mortgage. You’ll be in arrears.
Unlike in some countries – and several states in the US – you can’t walk away from this debt in the UK. You’re still liable for the shortfall, even though you’re no longer a homeowner.
There are rules, though. If it happens you’ll definitely want to seek advice.
And banks really don’t want to go down this road. It is expensive, and bad for publicity. They will usually try to agree some new payment schedule.
We can’t be sure that would happen in a really deep downturn, though.
Keep up your payments and you’ll be okay. But this is a mortgage risk, hence I list it here.
(Further) stock market crash risk
Fewer Monevator readers will need to worry about lower share prices with respect to their mortgage.
Indeed for most people in the accumulation phase of life, a stock market crash – and the chance to buy shares cheaper – is a good thing.
But if, like me, you’re on an interest-only mortgage that’s meant to be paid off by investment returns – or maybe you’ve still got a market-linked endowment mortgage from the 1990s – a drawdown in your portfolio could matter:
In the short-term, there’s the risk your portfolio falls a lot and at the same time your bank checks on whether your repayment vehicle is on-track. You can chant ‘be greedy when others are fearful’ to bankers all you like – they will only lend you an umbrella when it’s sunny. Banks will be spooked by a portfolio decline. This will probably limit your options if you want to agree a new deal – perhaps to address a projected shortfall – such as extending the mortgage term.
In the long-term, there’s a danger that your future investment returns leave the portfolio unable to cover the mortgage. In my case this would require negative nominal returns over the next 20 years! Not impossible, but I judge it to be low risk. You’ll have to do your own sums.
As I said, borrowers with endowment mortgages from the ’80s and ’90s have already trod this ground.
We don’t hear much about it now. Products and strategies were created to help usher older mortgagees over the line, and I expect many just sold into a stronger market and downsized.
The bottom line is anyone reading Monevator with an interest-only mortgage should be on top of their finances. Don’t assume another decade of high returns like the last one will bail you out. Contribute more money to your investments, or consider doing something else like shifting to a repayment mortgage or even selling up while house prices are strong.
Personal risks: health, job, moment of madness
Finally a broad catch-all covering all kinds of developments in your personal life.
Clearly if I could forecast whether you’ll be hit by a bus or suffer a stroke, I wouldn’t be writing a financial website.
However some kinds of massive disruption are predictable – and yet you might not have associated them with your mortgage before.
For example I’ve known couples set to divorce who’ve put off (un)doing the deed for years. This could be a big mistake if you find yourself having to divvy up a house in the midst of a house price crash, or if the main breadwinner is made unable to meet the payments.
Or perhaps you’ve known health problems that will eventually see you leave work, but you’re soldiering on for now? From the perspective of your mortgage it may be better to bite the bullet and downsize to get mortgage risk off the table, to avoid being hit by a double-whammy in the future.
I also think it’s fair to say the risks of running a mortgage increase with age – although there comes a point where it’s more your bank’s problem than yours!
The inescapable truth is a healthy young 30-year old has more time to correct missteps than a 60-something near-retiree. Act accordingly.
Be prepared
Given the shifting financial landscape, I believe it’s a good time for everyone to think about mortgage risk – and any upcoming remortgaging plans – and to consider what could go wrong.
Channel your inner Chicken Little. Imagine the sky is falling.
Could you be squished like a chicken nugget?
Let us know in the comments below.
In a couple of weeks I’ll return to my own mortgage, and give an update as to where I’m at as a result of all this thinking. Subscribe to make sure you see it.
