Perhaps it is the curse of frictionless trading and the rise of social media, or perhaps it is the unusually high returns delivered by global equities over the past decade, but investors seem more sensitive than ever to equity market declines. Even relatively minor ones like those experienced recently provoke dramatic responses.* At times such as these it is important not to lose sight of the fact that the returns from owning equities over the long run are as high as they are because they are volatile and suffer from intermittent drawdowns. We cannot have one without the other.

Starting with a very basic point – if we own a share of a company (hold equity), we carry the potential for a total loss of capital in the event that the business fails, and therefore we require adequate compensation for bearing that risk.

Thankfully, most investors are diversified across a large number of positions and are not entirely exposed to the fortunes of one company. We transfer the specific risk of part-ownership of a single business, to the broader market risk of holding a collection of them. This significantly reduces the range of outcomes we face – although we lose the potential for stratospheric returns from an individual holding, we also greatly diminish the prospect of disaster and complete failure.  

This diversification benefit is an attractive trade-off for most investors, but although it limits one type of acute risk, it does not remove risk entirely. Even diversified equity exposure comes with risks and uncertainty that require compensation. This, however, is a feature not a bug – absent this uncertainty long-term returns would be significantly lower.

I tend to think about the risk to diversified equity investors as stemming from two types of uncertainty – short-term behavioural and long-term fundamental.

The short-term behavioural aspect is consistent with Thaler and Benartzi’s explanation of the ‘equity premium puzzle’. Investors are sharply sensitive to short-term losses and check their portfolios frequently. The daily fluctuations of equity prices create a huge amount of discomfort, which leads to poor behaviours, particularly during times of market or economic stress. The fact that this short-term volatility bears little relevance to the very long-term prospects of the asset class is largely irrelevant as – in the moment we experience it – it feels vital.

This creates a major advantage to investors with a long-term mindset (or the inability to check their portfolio valuations every day) but is far more difficult to capture in practice than in theory.  

The long-term fundamental uncertainty element is simply that we cannot be sure what the results over time from equities will be. Although we can be confident that real returns from diversified exposure to equity markets will be positive if we hold them for twenty years – we don’t know whether this means 5% per year or 9%. Furthermore, we can never entirely discount the potential for very poor results from equities even over the long-run – the likelihood of this may be extremely low, but it is never zero.

These uncertainties combine to create high long run realised and expected returns for equities. If we were absolutely certain that equities would return 10% per year, then they would return a lot less than 10% per year.

There is a reward for bearing that uncertainty, but the catch is we do have to bear it. One of the biggest mistakes investors make is trying to capture the upside of equities while avoiding the downside. Given our dislike for even temporary losses this is entirely understandable, but incredibly dangerous, behaviour – one which is far more likely to act as a drag on performance than enhance it. The probability of us correctly anticipating and navigating each equity market drawdown (or prospect of one) is vanishingly small.

It is typically not the equity market declines that do long-term damage, it is the cost of the poor decisions we make during them. Such mistakes never come with just a one-off cost, they compound over time.

If we want to own equities for the long-term because we believe that they provide higher returns, it is important to understand why this is the case. Not only will this help us to manage the inevitably difficult times, but it will also allow us to shape our behaviour and time horizons to best capture those potentially high returns.  

—

* Minor declines, so far. (18^th March 2025)

–
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).