Elroy Dimson on how to think about bear markets

Posted by TEBI on December 22, 2019

Elroy Dimson on how to think about bear markets

In the first part of a two-part interview, the renowned financial market historian ELROY DIMSON explained how, in the short term, bull and bear markets are almost impossible to predict.

So, is there anything investors can do to protect their portfolios from bear markets? In the second part of our interview, Professor Dimson suggests some simple steps you can take to help maximise your long-term returns.


You explained last time how timing bull and bear markets successfully is exceedingly difficult. Why do we have bull and bear markets in the first place?

One way of thinking about is to think about the times at which markets are most volatile, and the times at which they’re less volatile. If you were to go back in history to the world wars and look at what happened to the equity market — and here I’m talking about the world equity market, weighted by the size of each country’s stock market — the decline was not particularly large, even over really terrible periods like those.

It was, of course, large for the countries that lost those wars. There was a very substantial decline for Germany over the First World War, and for Japan during and in the aftermath of the Second World War. But the big collapses come when people are euphoric, when they’re confident that nothing can go wrong. So in 1929, when people believed that security prices were at a high level and would stay there indefinitely, or in 1999, at the end of the tech boom — when that happens, people get confident that cash flows from companies will keep growing and that risk has become very small.

So, if people are very confident about the future, there’s a bigger risk of a big decline because that confidence may be misplaced. And, if risk goes up, stock prices decline. And that may occur at the same time as you see those cash flows, which you thought would grow at a very fast rate, proceeding to grow at a slower rate. So, oddly enough, it’s at times like those, when the world wasn’t in such a bad way compared to some of these other more extreme events, that markets can fall a great deal.


Why, then, have markets almost always recovered from setbacks? And how certain can we be that the very long-term trajectory of equity markets will continue to be upwards?

Well, as I’ve explained, stocks can be risky over long intervals. If equity prices simply vibrated, but continued in the same direction, that vibration would not really be a very substantial risk. People would be willing to pay almost as much for equities as they would for safer securities. The real problem is that you never know when there might be a really big collapse, which would affect many investors in a life-changing way.

So, it’s that risk of a downside collapse — of what happened in 2000 and 2001, or what happened in 2008 and 2009 — that makes investors less willing to pay a similar price as they would for keeping their money in a safe security. So, I think you can expect that equities will continue to perform well, but they’ll provide a relatively exciting journey.


You have partly answered this question already, but why are expected returns on equities favourable compared to safer assets?

We call the gap between the expected return on equities and what you would get from leaving your money in the bank, the equity risk premium. It is the premium you get for exposure to equity risk. Confronting equity risk — that is, the loss of savings that you hope will provide for your future retirement or whatever it is you’re saving for — can be painful. Therefore you would not expect to pay so much for assets that will expose you with some probability to that downside. You would expect equities to be cheaper and their return, over the long haul, to be larger.


You say you can expect equities to deliver higher returns than safer assets in the long run, but you can’t guarantee it.

There’s no sure thing in the equity market. If you need to be sure, you should not put a lot of your money into equities. Clearly, if you have a very long horizon and you don’t need your wealth in between, then you can take a long-term perspective. You are, in essence, taking a bet that, over a very long horizon, equities will perform better. But if you can’t bear the pain of underperforming, then you shouldn’t be putting too much into equities.


What you’re effectively saying, then, is that investors need to be patient. Is that right?

Patience is a virtue in the stock market. But there can also be times where you have no choice about being patient. Suppose you’ve lost a great deal of your investment; then, the patient solution is just to stick with it and, in the long run, you’ll be OK. But what happens if you’ve got some liabilities? What happens if there is a large expenditure that you need to make? You can’t be patient. So, patience is not just something which is in your heart and in your mind. It’s also something which will reflect external realities, whether you’ve got a major expenditure around the corner or are concerned about expenditures that are unpredictable, like ones that are to do with ill health. So, yes, patience is important. But not everybody can be patient indefinitely.


You said global diversification would have provided a degree of protection from the two world wars. Markets around the globe are more closely connected nowadays, but you still argue that diversification is crucial.

Yes. Diversification is one of the remarkable free gifts in the investment world. It’s one the lynchpins of investment. It’s essentially the one free lunch that you get when you’re an investor. With a portfolio which is spread across different stocks, different industries, different stock markets, different asset classes, risk is lower because, when one particular part of your investment portfolio does badly, another one won’t be doing badly. What history shows is that diversification will aid your portfolio by reducing risk. To put it in another way, if you’ve got a target level of risk, it will enable you to take somewhat more exposure to high-return assets because some of those risks come out in the wash when you have a diversified portfolio.


Finally, Professor Dimson, what would you say are the most important lessons for investors from all the research you’ve done over the years with colleagues like Paul Marsh and Mike Staunton?

The key messages from our long-term research are to do with the ingredients that you have to put into the cookery pot to come out with a good outcome. You need a high return, and you want to control risk, so one key message that we’ve talked about is the value of diversification.

The second thing that you need to think about is cost. Costs may look fairly modest in the short term, but a 1% difference in what you pay to invest per year, compounded over many years, has a very big impact. So the second thing, I would say, is cost control.

The third is the value of simplicity. It’s very difficult to have a strategy if it’s complicated and involves lots of change. So, a strategy of putting your money into a simple kind of structure, and a simple report on how you’re doing — that, I think, has more value than people appreciate.



ELROY DIMSON chairs the Centre for Endowment Asset Management at Cambridge Judge Business School, and is Emeritus Professor of Finance at London Business School. He chairs the Policy Board and the Academic Advisory Board of FTSE Russell and is an adviser to the board of TEBI’s strategic partner, Sparrows Capital
Did you miss the first part of this interview? Check it out at the link below:

Elroy Dimson on the problem with market timing


Image: Anna Tremewan (via Unsplash)


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