Market crashes are part of the volatility investor psychology bakes into the stock market. Large crashes are rare, but one can expect stocks to fall at least 10% once a year, 20% once every few years, and 30% or more once or twice a decade. A 50% or more drop, like we experienced during the great recession, only occurs once or twice during your lifetime.
Many investors have a hard time understanding this. They look at the financial markets and wonder why something so sophisticated breaks down constantly. They wonder why the stock market can’t just move at an even pace.
Economist Hyman Minsky explains this well, with his theory that stability is destabilizing. When stocks spend a long time on an upward trend or the economy goes a while without recession, that stability makes people feel relatively safe. When people feel safe, they take more risk, like acquiring more debt or buying more stocks. And, of course, people often go into to debt to buy more stocks, as is happening right now with near record levels of margin in investor brokerage accounts.
This Minsky economic theory is fairly air tight. If volatility in the markets did not exist, and we knew stocks went up 8% every year, the only rational response by investors would be to pay more for them, until they were expensive enough to return less than 8%. It would be almost impossible for this not to happen, because no rational person would hold cash in the bank if they were guaranteed a much higher return in stocks. If we had a 100% guarantee that stocks would return 8% a year, people would bid prices up until they returned lower than the level of inflation.
There are no guarantees in the stock market, only that perception exists from time to time. Negative events do happen, and when stocks are priced for perfection, a little bad news will often send them plunging. If stocks never crashed, or if investors hold the perception that they do not crash, prices would rise to the point where a new crash was guaranteed. This may sound odd, but it’s exactly at the heart of Minsky’s theory that stability is destabilizing. Since a lack of crashes leads to new crashes, markets will always crash, without exception.
This means that crashes are not simply a glitch in the system or a sign that the market is broken. Crashes are, in fact, very helpful for generating higher than average long-term returns. You may notice that I hold back some cash when the market is charging ahead, but fully invest when the market gets more choppy. As professor Jeremy Siegel said “Volatility scares enough people out of the market to generate superior returns for those who stay in,” Or as Charlie Munger (Warren Buffett’s partner) said: “You can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament to be more philosophical about these market fluctuations.”