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).