Are you a 'dolphin' or a 'pussy cat' investor?

Serious Money: 'The bull market is over" screams the headline. Various talking heads have emerged from the woodwork to warn us, in an unusually clear and forthright manner, that stocks are now going to fall.

"Equity prices will be lower in six months time," warns strategist at Morgan Stanley. Just what is it about Morgan Stanley that leads them to employ such pessimists?

Don't they know that investment banking is about being bullish?

Recent wobbles in equity markets are being laid at the door of inflation. Apparently, markets have suddenly decided that all those rises in oil, copper and other commodity prices now mean that inflation is going to be a global problem. Shades of the 1970s, I suppose.

Markets, of course, are very fickle creatures. By the time this article is printed, we could have seen them turn on a sixpence - "things don't look quite so awful" - or continue to fret about incipient inflation.

Let's assume, for the moment at least, that all of these worries are soundly based and that the chap at Morgan Stanley is right. What should an investor do?

In a falling equity market, you can employ any one of a number of strategies. I'll focus on three, calling them pussycat, tortoise and dolphin.

Strategy number one - pussycat - is called for if you are a pessimist by nature and risk averse to boot.

The chance that stocks might go down for six months - or even longer - scares you half to death. If you find something of yourself in this description, you should sell most of your equities now.

Truth be told, you should probably never have bought them in the first place: people with your outlook are best suited to bank deposits and government bonds.

Second, there is the tortoise strategy. This is where we have an investor who is reasonably aware of the inherent volatility of equity markets, is able to take some pain over, say, a one-year time horizon, but does not have the financial capacity and/or mental strength to withstand a sustained fall in equities like, for example, the one that took place over the period 2000-2003. This type of investorshould reduce - but not eliminate - holdings of stocks and rotate a few positions into classically defensive areas like tobacco and pharmaceutical equities. These latter are widely assumed to do relatively well in bear markets.

Two points to be made here. First, remember that "relatively well" means that these stocks can still go down, but just not by as much as other, more cyclical, areas of the stock market. Second, these style-based rules of thumb are models of market behaviour that many people seem to believe in, but are ones that often do not stand up to any empirical scrutiny.

At times like these, beware hacks and charlatans bearing "investment clocks" and "sector rotation schemes" that purport to tell you how to protect your cash in difficult times. If this really is the start of a bear market, get used to the idea that you are going to lose money either quickly or very quickly.

Third, there is the dolphin strategy. This will appeal to the investor who knows a bit about stock market history and has a reasonably upbeat view of the future of the global economy - even allowing for the inevitable hiccoughs. Our dolphin strategy requires a large tolerance of risk and a deep pocket that can withstand the steepest part of the rollercoaster ride that stock markets always offer. The dolphin strategy tells us to get our cash ready - and be prepared to use borrowings if necessary - and to start thinking about the stocks we are going to buy as the market falls.

History teaches us that stocks go up more often than they go down. A study of the past also tells us that the truly apocalyptic event for equity markets is to be situated in a country that loses a war. Sure, wars are bad, initially, for all markets, but they are much worse for the eventual losers. Inflation comes a distant second as a negative driver: even Weimar Germany saw stocks do very well. Between 1920 and 1939, equities returned a real 6.1 per cent per annum gain, on average.

Indeed, Germany more or less replicates the experience of pretty much every major equity market since they were invented: the only non-war decade that saw equities fall in real terms was the 1970s. In Germany, stocks returned a negative 2.5 per cent per year during that awful decade. The equivalent figures for the UK and US markets were -1.4 per cent and -0.7 per cent. (Irish stocks actually recorded a positive 0.5 per cent annual return during the period. Japan also did well.)

The reason markets get so exercised about inflation is because of very imperfect recollections of the 1970s. Everyone imagines that they were truly awful for investors. The UK, for instance, saw an investor lose 1.4 per cent of his money every year. Doesn't sound much, but compounded over 10 years, you would have lost close to 15 per cent.

But, given how awful everyone thinks the 1970s were, I'll bet that most people will be surprised at how "low" that 15 per cent is. Incidentally, bonds and cash were actually worse places for your money: that's what an average annual inflation rate of 13 per cent will do to the real value of your money.

Quoting decade-long averages means that I am ducking a lot of the volatility that went on year by year. As a matter of fact, equity holders got pretty wiped out in 1973 and 1974, with falls in the market of around 25 per cent and 50 per cent respectively. But stocks went up 145 per cent in 1975 and had a positive return in every subsequent year until 1990. An ugly and violent ride for sure, but anyone who stuck out the volatility - and had a sufficiently diversified portfolio - survived to fight another day.

The lucky ones who bought in 1974 - just after the first oil shock - made a lot of money.

If the current inflation scare is real, it won't be anything like the 1970s. And the 1970s were not as bad for stocks as is popularly supposed.

Why do I call my third investment style the dolphin strategy? As the late, great Douglas Adams said, dolphins are by far the smartest creatures on the planet.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.