Although I am averse to making financial market forecasts, I can say with some level of confidence that over any long-run horizon most investors will have to encounter painful periods of losses in equity markets. Some seem unaware of this (or at least behave as if they are) while others spend most of their time attempting to predict when such phases will occur. Neither of these will lead to good outcomes.

If I am confident that severe declines will happen, do I have anything to say on when they will arrive? No. I have little idea. The next one might begin tomorrow, or in ten years’ time. They have transpired in the past and will happen at some unpredictable point in the future.

The difficulty of experiencing and living through tumultuous times mean that many, many investors dedicate themselves to reading the runes of financial markets. Seeking that ever elusive goal of capturing the higher returns available, while avoiding the downside risk that comes as part of the bargain.

This is a fool’s errand.

The cost of consistently attempting to predict the next equity market drawdown – and often being wrong – will be pernicious and permanent. The compound impact of these poor decisions will likely do far more lasting damage than the next bear market we experience.

If we are not busy predicting the gyrations of equity markets, the other major risk is that we are not expecting such drawdowns to occur at all.  While we should always be surprised at the cause and timing of a bear market (because they are difficult to predict), we should not be shocked when they arrive. All investors must have their eyes wide open – they are a feature of equity investing, and they will feel awful.

To have a chance of benefitting from the compound impact of long-run investing, it is not enough to tell investors to focus on the distant horizon and everything will be okay. We must acknowledge that to get to that point we will have to live through some difficult months and maybe years.

When equity markets have performed well it becomes particularly easy to be complacent about the potential for future losses. This is because we are prone to extrapolate – if things are good now, we struggle to see anything else in the future and will often be entirely unprepared for experiencing a very different world.  

So, if we cannot predict torrid market conditions but equally should not be surprised by them, what should we do? We cannot simply say – equities could fall by 40% – that is an anodyne statement which is easily dismissed. Instead, we need to create some vivid expectations about what the landscape might be like. We won’t know precisely what will happen but there are patterns of behaviour that are likely be a feature:

– Economic news will be terrible.

– Financial market performance will be prominent on the general news.

– Everyone will become an expert on ‘the thing’ that has caused it.

– Investor behaviour in the run up to the bear market will appear wholly irrational and naïve.

– There will be constant images of red screens and traders with their hands on their heads.

– Certain styles of investing will be declared dead.

– Investing for the long-run will be professed as an outdated concept of a bygone era.

– Some forecasters will be claiming that this was inevitable having been predicting such an occurrence for 14 years.

– Some market forecasters will be predicting the end of the financial system / world as we know it.

– Everyone selling equities and holding cash will look incredibly smart in the short-term.

– It will be stressful and anxiety inducing.

– We will be checking markets and portfolios constantly.

– There will be stresses over liquidity in certain asset classes.

– It will feel like things are getting worse every day.

– Some hedge fund managers will become incredibly high profile for being so sagacious.

– Weeks will feel like years.

– All valuation metrics will be considered worthless because none will consider quite how bad it will get.

– Nobody at all will be thinking about the long-term.

– It will be difficult to envisage things getting better.

– Getting out of risky assets will probably prove irresistible.

Making smart decisions during these times is extremely difficult and simply talking about what it might be like will not make us immune from the psychological challenges. If, however, we set expectations that events like this are likely to unfold over the life of our investments (even if we cannot forecast the cause) it does make it somewhat easier to cope with them and, hopefully, follow the plans that we have in place.

It is also reasonable to assume that we are more vulnerable than ever to damaging choices in such environments. Not only have equity returns been unusually strong in recent years but we have more access to information, are more connected through social media and can trade more frequently. Fear and anxiety are more readily stimulated, and we can remove it with a couple of taps on our smartphone. It is easier than ever to make choices that feel good in the short-term but come with a long-term cost.  

Investors in equities win over the long-term by being optimistic, but that alone is not enough. We also need to be sufficiently realistic to understand that the long-term will include some torrid periods that will present the most exacting behavioural tests. If we don’t plan for those short-term challenges, we are unlikely to reach our long-run goals.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

Paul Richards and I were having a conversation recently about whether AI technology was making it easier to spot lies and deception. He asked me how I thought a ‘truth machine’ would impact the asset management industry and I responded (with tongue somewhat in-cheek): “it would destroy it”. This was the inspiration for our latest Decision Nerds episode where we discuss lies, mistruths and obfuscation.

In the episode we cover:

– A top five countdown of our favour asset manager ‘fibs’.

– Research that shows that while investment analysts think they are good at knowing when they are being lied to, they really aren’t.

– Whether AI is really better than humans at detecting lies.

– Why industry norms are likely to penalise the most open and transparent asset managers.

– How would a ‘truth machine’ impact investors and asset managers.

And lots more.

You can play the pod via the link below, or access at your favourite pod places.

Decision Nerds – Lying

When an online poker firm published analysis of 120 million starting hands (hold ’em) played through its website, its analysis showed that of the 169 non-equivalent beginning combinations only 40 were found to be profitable. Furthermore, half of all profits were attributable to five hands (AA, KK, QQ, JJ, AK-suited). Given this skewed distribution of outcomes a winning strategy seems immediately obvious, but all is not quite what it seems. Why is this the case, and what does it mean for investors?

An initial glance at the data might lead us to believe that the optimal approach is simply to avoid making large bets until we are dealt a hand with a disproportionately high probability of success. The problem of course is that in a game of poker we do not make decisions in isolation – other players will observe and react to our behaviour.

If we were only placing bets of consequence when we had extremely strong hands, it would be incredibly easy for most players to spot this. Our seemingly optimal strategy would quickly become the obverse.

Similar to poker, there are not likely to be that many investment situations where the odds of a positive outcome are firmly on our side, but unlike poker most of us don’t have to worry about other investors directly anticipating our behaviour and compromising our returns. Does that mean investors are free to wait for those the most attractive of setups – the proverbial ‘fat pitch’?

Unfortunately, it is not that straightforward. There are three reasons why:

– We are not sure what a strong hand is: Identifying circumstances where the probability of superior performance is elevated is not simple. In poker it is evident when we have a strong hand, but in investing there is inherently more uncertainty and variability through time. (Somewhat ironically, the most attractive situations are likely to arise at times of valuation extremes – the exact point where we are likely to believe that the odds of a positive outcome are poor).

– We will misjudge when we have a strong hand: Our conviction will almost inescapably be driven by what has performed well in the recent past, particularly if it is supported by a persuasive narrative. This will create the perverse scenario where our confidence increases as the likelihood of a good result decreases. Unfortunately, we are more likely to bet big on a bad hand.

– We will play too many hands:  In poker we need to play more hands than might seem ideal to keep other players from predicting our behaviour; whereas in investing we trade more than we should because there is an expectation that we need to be constantly active. The investment industry rewards heat not light. Markets are noisy and chaotic, perpetually generating new stories and discarding old ones. Each month or quarter the focus will be on a shiny new topic, and we are expected to react. There is a bizarre value attached to being a busy fool, with very few investors afforded the luxury of time and patience.

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The inherent unpredictability of financial markets allied to our own behavioural foibles means that investors are vulnerable not only to playing far too many hands but also increasing our stake as the odds deteriorate. Although this is a path to poor returns it does give us plenty to talk about while we get there.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).