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Thursday 18 August 2011

Triumph of the Pessimists

Bad Stuff Happens

Given that markets are pursuing their favourite pastime of bouncing up and down like a manic depressive doing the Hokie Cokie on a Space Hopper, investors might be forgiven for wondering what they should do next. Fortunately the world is full of people offering sage advice. Unfortunately none of it is very useful, at least where 20:20 foresight is concerned.

The underlying lesson is, perhaps, an odd one.  We should invert the normal mindset of the average investor, who's an inveterate, if rather foolish, optimist, and proceed on the basis that something is always about to go badly wrong.   After all, it nearly always is.

Time Travelling Idiots

When markets become tumultuous, which is often, lots of people pop up to explain what’s going to happen next. Many of their arguments are highly plausible. Sometimes they’re well written. Occasionally they’re both. Unfortunately, unless physics is completely wrong and time travel is actually possible they’re all engaged in an activity we usually call ‘guessing’.

Although this is often entertaining, spending a lot of time reading this stuff is pretty much a waste of time when it comes to investment. After all, in 1939 markets completely failed to take account of the possibility that Hitler might run amok in Europe despite small hints like the invasions of the Rhineland, Austria and Czechoslovakia.  As we saw in Why Markets Crash they didn’t spot the First World War either: so a perfect record when it comes to global conflagrations, then. 

Meanwhile, in 1987 stockmarkets collapsed for reasons no one has yet been able to agree upon, let alone figure out how to predict (see Black Swan Down). In fact, if anything, if you and I can see a crash coming there’s a reasonable chance even the buffoons that run the world’s finances might manage to avoid it.

Although it'd be best not to count on it.

Danger, Private Investor

There's a wider issue, though, because the accepted wisdom is that even if stuff goes wrong in the short-term you can't go wrong if you invest in stock markets for the long-term, a period usually defined as about twenty years. Unfortunately, as Elroy Dimson points out in Triumph of the Optimists:
“While a country has only one past, there are many possible futures. The likely rewards from equity investment are worth having over the very long haul. Yet the risk of shortfall is always present, even over lengthy investment horizons. Investors should not assume that favorable equity returns can be guaranteed in the long term; nor should they assume that stocks are safe so long as they are retained for a holding period of at least twenty years.”
Moreover, the evidence, such as it is, for our immediate future is not particularly encouraging.  History doesn't perfectly predict what'll happen next but in Growth in a Time of Debt Carmen Reinhart and Kenneth Rogoff show that when countries become heavily indebted the process of paying this off – deleveraging, in the jargon – can take a long time and significantly impacts future growth:
"Over the past two centuries, debt in excess of 90 percent has typically been associated with mean growth of 1.7 percent versus 3.7 percent when debt is low (under 30 percent of GDP), and compared with growth rates of over 3 percent for the two middle categories (debt between 30 and 90 percent of GDP)."
Of course, growth is what markets thrive on, so when they figure out there may not be much coming they can discount the future quite heavily. Cue a time of falling knives and yo-yoing markets.

Managing Panic

The trouble is, though, that there’s always a crisis looming somewhere – as we saw in Losing the Lender of Last Resort you don’t usually have to wait very long before the next stockmarket panic comes along. Even if our current spate of woes is actually the start of a long and miserable period for stocks generally we can’t just ignore this and hunker down in a bunker.  In fact, we should attempt to embrace it. Here’s one of my favourite quotes:
“With the possible exception of the 1960’s there has not been a single decade in which there was not some period of time when the prevailing view was that external influences were so great and so much beyond the control of individual corporate managements that even the wisest common stock investments were foolhardy … Yet every one of these periods created investment opportunities that seemed almost incredible with all the advantages of hindsight”.
That’s Philip Fisher, from Common Stocks and Uncommon Profits.  As Fisher points out, these periodic crises of confidence will, barring the end of civilisation as we know it, turn out to be wonderful buying opportunities, even in the terrible low-growth conditions we may experience today: equities may not be a sure-fire investment even over twenty year periods, but if you can buy cheaply enough now that won’t matter.

Deflationary Anchoring

So a sensible pessimist should take the view that there’ll be a crisis along in a minute or two and, no matter what the conditions, this will actually throw up decent buying opportunities, assuming we actually have some cash to invest: and a pessimistic investor will always have some bonds to sell or some cash to hand.  However, even knowing this, investing in falling markets is mentally extremely difficult and requires diligent preparation.

The psychological issue arises from the tendency to wait for a better opportunity, which can lead to missing the chance altogether. This is quite a dangerous behavioral trap, due to a nasty trick of the mind well understood by psychologists: the problem of deflation.  Deflation is really a form of market failure, when everyone starts doing the same thing – in this case putting off buying today because they reckon they can buy cheaper tomorrow.  When everyone does this prices can fall regardless of fundamentals.

Of course, the trouble with this mindset is that the time to buy is never right: you don’t buy on the way down, because stocks will be cheaper tomorrow, and you don’t buy on the way up, because you’ve anchored on the lower price.  Unfortunately, anchoring – the tendency to attach ourselves to a particular number, such as a buying price or a market high – is also dangerous if we do buy, because lots of investors operate on the basis that if a share price has fallen a long way then it must be cheap.  Sadly if a stock is a crock then a big fall may simply mean there’s a bigger one ahead: in falling markets analysis of company fundamentals is even more important than normal.

Time Horizons

What with the combination of these correlated waves of behaviour driving markets lower and the prospect of low growth and poor returns for many years it’s dangerous to throw all of your spare cash at the market in one fell swoop. Again our pessimism should dictate that although some panics end quickly others don’t, and we need to manage our downside risks. Of course, this equally applies if you have a lump sum to invest in a bull market: you don’t ever want to put all of your money into the market at the same time, just before another crash.

There’s not a lot of research into time horizons over which lump sums should be invested, and what there is, is mainly focused on index funds. However, the basic idea is to move your money into the markets over a period of not less than six months and not more than twelve. This is a risk management strategy, aiming to reduce the worst possible outcome, of a market crash while you’re investing: in effect , investing over shorter periods has pretty much the same effect as investing a lump sum.

Pessimism Rules

None of this really should be a surprise to good investors. Keep some cash ready for a rainy day, don’t invest it all at once, don’t buy stocks just because their price has fallen or without fundamental analysis and don’t expect stock markets to give you a guaranteed positive return just because you’re taking on more risk. 

Being a pessimistic investor is an important state of mind but we need to keep things in proportion.  After all, if we were really pessimistic we wouldn’t invest in stocks at all.

Common Stocks and Uncommon Profits and Other Writings (Wiley Investment Classics)Triumph of the Optimists: 101 Years of Global Investment ReturnsThis Time Is Different: Eight Centuries of Financial Folly


  1. Spot on. Pessimists buy bonds, optimists buy equities. Pessimists have been right.

  2. Uh.. the last time I checked investing lump sums in one go was preferable from spreading out the investment over months, provided that you plan to hold for a long period of time (like 20 years).. because withholding the investment in an (on average) rising market tends to have a large discounting effect in the distant future. So it would be nice to see your calculations/data before you dole out advice.

  3. Hi cleeray

    The evidence, such as it is, is linked to in the article, but is predicated on the idea of minimising the downside rather than maximising the upside. Regardless of the averages it's impossible to deny the point that if you throw your lump sum into the market just before a crash you will end up, in 20 years time, with less money than someone who puts it in afterwards. So the question is, do you feel lucky? And if you don’t, how do you propose to manage that risk? Because if you’re the unlucky statistic you’re the one living off baked beans in your old age. Consoling yourself that you were unlucky won't make much difference then.

    In any case, as the article points out, 20 years probably isn’t enough to minimise downside risk. This number is another myth, an accidental statistic born out of the limitations of our existing data set – i.e. our unique past. Re-run the tape of history again and you might get a different result. The point of the research quoted is that they’ve done their best to replicate this by looking at other markets, and the result’s not so good. Put your lump sum in the markets at the wrong time and you may be dead by the time mean reversion kicks in.

  4. great post, thanks for sharing