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Seth Klarman: How to Act in a Bear Market

Advice from the renowned value investor

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Rupert Hargreaves
Dec 06, 2017
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In today’s market, after nearly a decade of low volatility and steadily rising stock prices, it is easy to forget the turmoil that gripped the stock market, and the world, in 2008-09.

Even though a crash might seem a million miles away currently, you never know when the next decline might arrive, so it is always best to prepare for the worst. The best way to prepare is to read accounts of investors given at the time.

This will not give you answers as to when the next crash will arrive (all but impossible to predict), but it will provide a sort of template as to what goes on.

Learning from Klarman

One of the most fascinating accounts of investing during the crisis comes from

Seth Klarman (Trades, Portfolio). In February 2009, Klarman wrote an article in Value Investor Insight titled, "The Value of Not Being Sure." Within the article, he detailed how he was investing in the crisis and why he thinks fear is such a great motivator. 

Klarman begins his piece discussing the need for investors to separate the ideas of volatility and risk. He then goes on to note that with markets down 40% to 50%, this might be difficult as “there is a vicious circle in effect (the reverse of the taken-for-granted virtuous circle that buoyed the markets and economy in good times). This vicious circle results from the feedback effects on the economy of lower securities and home prices and a severe credit contraction, and, in turn, effects of a plunging economy on credit availability and securities and home prices.”

In such an environment, it is difficult to find winners above the refuse. Bargain hunters who jumped into the market in 2008 went on to be “surprised by the magnitude of the selling pressure” and “extent to which deterioration the business fundamentals has come to justify the lower market prices.”

This problem is just part of the value process, Klarman said. Not all declines are equal. The weaker companies will fail, weaker investors will sell out at the bottom and value investors, who are prepared to wait, will be well rewarded.

“It turns out you won’t be able to accurately tell who’s been swimming naked until after the tide comes back in.”

He goes on to say that trying to time the market, especially in the throes of a bear market, is a waste of time. You will not be able to pick the bottom and prices rise quite quickly. The best method is to choose your bets and then weather further declines if they materialize.

“While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed...the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better.”

Markets are not controllable, but your process is. As Klarman notes, “Controlling your process is absolutely crucial to long-term investment success in any market environment.” A focus on process, not outcome, will help you make the right decisions in a falling market and not become a slave to your emotions, which may lead you to make mistakes.

Part of the process has to be flexibility. Investing is an uncertain business, and no matter how rigorous your process, you should be prepared to make changes if the facts change as well. This is Klarman’s defense of uncertainty. He argues that uncertainty motivates diligence as “one pursues the unattainable goal of eliminating all doubt.”

“It is much harder psychologically to be unsure than to be sure; certainty builds confidence, and confidence reinforces certainty. Yet being overly certain in an uncertain, proactive, and ultimately unknowable world is hazardous for investors. To be sure, uncertainty breeds doubt, which can be paralyzing. But uncertainty also motivates diligence, as one pursues the unattainable goal of eliminating all doubt. Unlike premature or false certainty, which induces flawed analysis and failed judgments, a healthy uncertainty drives the quest for a justifiable conviction.”

Overall, Klarman believes process and uncertainty are the keys to surviving a downturn and managing a successful investment process in general.

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