A crash course in stock market crashes
October 12, 2022
5 minutes to read
A stock market crash can significantly affect your portfolio return (and your mood). So what do you need to know about stock market crashes and what can you do if you are afraid a crash is coming?
1. Crashes are part of investing
Just like the economy occasionally needs a good clean to weed out any unhealthy companies, the stock market also benefits from a detox every now and then when valuations are too high and/or investors are starting to show manic behaviour. A sharp fall is therefore par for the course.
Crashes are certainly not new. There have been many crashes in recent history: the Great Depression starting in 1929, Black Monday in 1987, the dot-com bubble burst in 2001, the financial crisis of 2008 and more recently the pandemic in 2020. But even before that, as far back as the 18th century, crashes were not exceptional.
The good news is that despite all these crashes, the markets have always rallied. Of course, this is scant comfort to those with portfolios that have fallen by 20% or even 30%, but nevertheless, it is an important fact to remember. Boffins at Credit Suisse have calculated that diversified investments in equities have enjoyed a 5.3% average annual return since 1900. That is a real rate of return of 5.3%, so after the rate of inflation is taken into account. This is certainly not bad, if we consider all the (world) wars, pandemics, crises and so on that have come to pass since 1900.
A more recent example? Say you started some new investments exactly one day before Lehman Brothers collapsed in 2008. You would think you couldn't have chosen a worse time. If you opted for an investment that tracked the MSCI World index, it would have gone 30 to 50% into the red in the following months depending on the currency of your investment. True, that seems truly horrible... But if you simply held on to your investment, it would have more than quadrupled again by now!
We can conclude that stock market crashes are actually not very significant to people with diversified, long-term investments.
2. When, how deep and for how long?
There is always a great deal of talk about the stock market. Every day now we hear some prophet of doom announcing the stock market's impending crash. Nouriel Roubini, for example, the well-known economist who predicted the crash of 2008, sees signs of a new catastrophe almost every year. Crash prophets are bound to be right from time to time, but none of them manage to predict crashes consistently. Predicting when the next one will come is not an exact science.
How long will it take to recover? After the 2020 crash, the S&P 500 US star index only took 5 months to recover fully. The other extreme happened after the 1929 crash, when the precursor of the S&P 500 took 22 years to get itself back to its previous nominal level (without taking into account inflation). For the period from 1835 to 2020, Goldman Sachs calculated that it took 39 months (median) to return to the S&P 500's original level (nominal). And of course, these figures have no predictive value either. Nobody can predict how long the stock market will remain in negative territory after the next crash.
How deep will the crash go? That too is impossible to predict. A crash is a rapid and dramatic decline in the equity market. The biggest drop in the S&P 500 in a single day was -20.47% on 19 October 1987. A bear market is when an index price falls by more than 20% compared to the previous peak. The biggest bear market was a drop of 85% in the period from 1929 to 1932.
We can conclude that there is no point in trying to time a crash. No one can consistently predict when the next crash is coming, how long it will last or how deep it will go. Rather than anticipate a crash (and continuously dancing in and out of securities), it is usually more sensible to simply stick with your investment.
3. Concerned about a possible crash? Here are a few tips.
Even though you now know that the markets will always recover and there is no point in timing the market, when that crash does come, your instincts may be telling you to act (and sell your investments). These tips will help you to resist that temptation:
Regularly check whether your investments still correspond to the risks you can and want to take. Certain events may mean that you should reduce or increase your risks. For example, you may be about to retire, your family or work situation may have changed or you may have received a gift or an inheritance. Do this exercise once a year. Does your portfolio match your risk appetite or risk aversion, your financial knowledge, your investment horizon, etc.? A crash may make you want to swear a little under your breath when it happens, but beyond that, it should leave you more or less indifferent.
Unless you are extremely passionate about investing or investing is part of your job, reading the Wall Street Journal every day, skimming through stock market forums and analysing price charts may not be the best use of your time. It will probably only make you more anxious, which will then increase the risk of impulsive decision-making. A great way to curb your news addiction is to read the stock market news of about a week or a month ago. Don't listen to the current noise and focus on the long term. Monitor the performance of your investments regularly, but not constantly, for example every three months.
Diversify, diversify and diversify. This allows you to even out (temporary) losses in the event of a crash. Some sectors and investment themes will be far more resistant to a crash than others. Depending on your risk appetite, diversify across various asset classes as well: don't just focus on shares, but also look at bonds, commodities, precious metals, etc.
Consider investing regularly with KEYPLAN to prevent emotionally charged decisions. You set up an automatic order to invest some of your money each month. This means you will never invest a large amount of money 'at the wrong time'. Every crisis offers opportunities. And major crises offer major opportunities. A crash can therefore also be an excellent time to buy. At a time when everyone is selling, it may be interesting to adopt a bottom fishing strategy.