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Understanding Markets

How to Think About the Next Bear Market, Recession, or Risk

There’s a difference between having expectations for the future and making a forecast.

Articles by Morgan Housel

By Morgan Housel
Partner, Collaborative Fund  |  Published: January 11, 2019

Even weather forecasters with reliable evidence know that a precise future prediction is unlikely to be very accurate.

In place of forecasting the future, you may find it more useful to expect events to take place from time to time, even without being sure when they’ll occur.

Holding a marginal amount of money in safer assets can help avoid the human tendency to make specific forecasts.

Ken Arrow was a weather forecaster during World War II. But Arrow—who went on to win the Nobel Prize in economics—realized after a while that his team’s weather forecasts of European battlefields weren’t very good. He asked his superiors if he and his team could stop publishing them.

The reply came: “The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.”

This well-known story is often used to show how desperate people can become when seeking a crystal ball, clinging to forecasts despite their track record.

But there’s another way to view this story. And it can help investors think about the future in a smarter way.

Expecting the future to happen is different than forecasting the future.

There are two ways to think about what the future might hold:

You can have a forecast, which is foreseeing a specific event taking place during a specific time.

Or you can have an expectation, which is anticipating that specific events will take place from time to time, but you’re not exactly sure when.

“There will be a bear market (stocks falling 20% or more from their high) in 2019,” is a forecast.

“Since the end of World War II there has been a bear market roughly every seven years, and I expect that tend to roughly continue,” is an expectation.

“It’s going to rain Friday,” is a forecast.

“June receives an average of four days of rain,” is an expectation. And it’s what I imagine Arrow’s Commanding Generals were interested in.

Set informed expectations to help invest with less disappointment.

Expectations can be way more useful than forecasts, for two reasons.

One, they don’t rely on trying to tame something as monstrously complex as the stock market down to a specific point in time. So they’re just easier to handle.

More important is the difference they can have on your investing behaviors.

If I forecast that the stock market is going to fall 20% in 2019, what could I do about it? Maybe I should sell my stocks now. But then what if I’m wrong? When do I throw in the towel on my forecast and buy stocks again? Even if I’m right and stocks do fall 20% next year, how much further will they fall? When should I buy back in?

It’s endlessly complicated. And complexity easily morphs into disappointment.

But if I have an expectation that the S&P 500 has historically declined 20% or more roughly once every seven years, I can set up a diversified portfolio—padded with bonds and cash—that’s designed to absorb volatility without having to know exactly when it’s coming. Then when someone asks, “Is the market going to fall 20% next year?” I can honestly answer, “I have no idea. Maybe it will, and I’m prepared for that. Or maybe it won’t, and that’s fine too.” And when a big decline does come, it doesn’t scare me, because I wake up every morning with the expectation that, historically, this kind of stuff is normal.

Which is such a more sustainable position to be in over time.

Benjamin Graham, a great investor, has a quote I love:

“The purpose of the margin of safety is to render the forecast unnecessary.

If you have a margin of safety—meaning room for error—in your household budget, or by having a chunk of your assets in cash and bonds, you don’t need to know whether we’re going to have a recession this year. You don’t rely on that forecast.

Evidence to help you reset your expectations.

Here are a few stats from economist Ed Yardeni that I use to help set my expectations as an investor:

  • Since the end of World War II, the S&P 500 has declined 10% or more on average every 20 months, according to Yardeni. That’s not every 20 months, of course—there’s a lot of variability. And the future could be different. But using that as a baseline expectation of market volatility can be smarter than trying to forecast what will happen next.
  • The S&P 500 has declined 20% or more on average every 7.6 years.
  • It’s declined 40% or more three times in the last 73 years. So that’s something you might expect to happen a couple times during your life as an investor.
  • There have been 11 recessions since 1945. The time between one recession and the next has averaged 58.4 months, or about once every 4.5 years.

I spend virtually none of my time as an investor forecasting when any of these events might happen, but lots of time building both a portfolio and a mindset that is prepared for them, whenever they might come. My goal isn’t to know what’s going to happen next year; it’s to survive as an investor for the next 20, 30, years or more. That’s when compounding can work the best.

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