Being prepared for market setbacks starts with sound expectations

One of the most important attributes for any successful long-term investor is adopting (and keeping) a low time preference. This means you don’t worry about short term fluctuations in the market, but instead have your sights firmly set on the bigger picture. In Jim Rogers book, Hot Commodities, he gives the example of investing in gold during the 1960’s and 1970’s as the perfect example of taking that longer term view:

“In the late 1960’s, for instance was at $35 per ounce. In 1975, it rocketed to $200 in anticipation of the recent decision by the US government to allow Americans to own gold again. Within the year, gold lost 50 percent of its value, plunging back to $100. A lot of people sold their gold. Too bad for them, because gold proceeded to go straight up eight and a half more times – to $870 an ounce in January 1980.”

Unfortunately, no market goes up steadily, either at a nice 45 degrees or a gradual step by step ascent. Nope. Instead you get gut wrenching pullbacks that leave you questioning your sanity and testing you why ever invested in said commodity or asset in the first place.

Often its being too immersed in the minutiae of the day to day movements in the markets which means you lose sense of the bigger picture. When setbacks come – they have and they always will – it’s better to zoom back out to see how far you and the market you are looking at has come, and how much further potential there is. Only then can you see a sharp drawdown as a short-term setback and be able and willing to take advantage of them.

“No bull market in any asset has ever gone straight up; periodic corrections will always occur…there will be corrections; things will go down. And when they do the smart investor will buy more.”

But to stomach periodic drawdowns requires three things. It means getting in early so that a setback doesn’t mean you’ve lost any of your original capital. It means knowing when the odds are stacked in your favour, and when to take risk off the table if the odds start to favour the downside. It means having a plan for what to do if/when the tables turn.

“Investing is the only business I know that when things go on sale people run out of the store.” – Mark Yusko

One way you can plan for what to do is by completing a decision journal. This should detail everything little detail about a trade or investment (completed before you take a position, not after). It should include your reasoning behind the investment, what signposts you anticipate to cross as time goes on (signalling good, or bad news lies ahead), what would have to happen for you to reconsider your position (both price and events) and finally an idea of the volatility you can expect.

Understanding expected volatility is central to being able to cope with setbacks and planning what to do when the inevitable happens. If we have an expectation that our portfolio will serenely grow by 7% per annum over the long term but fail to check that past returns have been prone to wild swings then we’re likely to sell at the first sign of trouble. Looking back at the stockmarket crash of 1929, WSJ columnist Jason Zweig concluded:

“To be a long-term investor in stocks, you have to be prepared to lose more money for longer than seems possible. Anyone who takes that risk lightly is likely to sell out, in the next crash, near the bottom.”

Being aware of the likely degree of volatility means that you can be smarter at sizing your trade or investment; there’s nothing worse than being forced to sell out or being too emotionally wrapped up in the success of an investment. Being aware of the the likely degree of volatility means you can recognise when the market moving against you is just normal. It was expected. If the investment case remains strong, the odds are in your favour once again providing the opportunity of a second bite of the cherry.

This is post number 5 of a series of 7 articles.

Article number 1 – The Catalyst. Article number 2 – Pay attention to what others neglect. Article number 3 – Attention to detail separates success from failure. Article number 4 – The art of masterly inactive investing: Knowing when to do nothing

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