6 things to know about stock market crashes

Aug 02, 2022

In 10 things equity investors should never forget, we briefly list some well crafted market rules every investor must know.

This time, PAUL KAPLAN, director of research for Morningstar Canada, shares his observations on his extensive research on market declines. Following convention, he uses the term bear market to refer to a downturn of 20% or more.

  1. Nothing beats diversification.

Markets are unpredictable. Not all crashes are alike in their severity and duration. Naming the market’s peak or bottom is extremely difficult. Therefore, the best bet is to prepare now for the next crash by owning a well-diversified portfolio that fits one’s time horizon and risk tolerance.

  1. No one can predict the duration of a crash.

From time to time, stock markets go through long and deep periods of decline. After a large decline, it is hard to predict how long it will take for the market to recover.

The Lost Decade: The 54% drop from August 2000 to February 2009, started when the dot-com bubble burst. The market did not get back to its August 2000 level until May 2013—almost 12 and a half years after the initial crash.

The Pandemic Crash: After a decline of 20% (in real terms) from December 2019 to March 2020, the U.S. equity market fully recovered in just four months and was back to its pre-crash level by July 2020.

One can never predict how fast a recovery will be.

  1. Sometimes, the market and economy move in opposite directions.

The year 2020 was a stark reminder that the stock market is not the economy. The economy was saddled with COVID-19 restrictions on economic activities, and unemployment was high. But the market moved relentlessly higher.

  1. Those who stay the course are rewarded.

When invested, there is always the possibility of depressed markets and extreme events. These events can be frightening in the short term. But over the very long run, stock markets have been very generous in rewarding those investors who can get through long periods of decline.

Despite downturns, some of which were quite long and severe, $1 invested in the U.S. market at the end of 1870 grew to $20,514 in real terms at the end of May 2022. This is a real annual rate of return of 6.8%.

When the market bottomed out in February 2009. From then through May 2022, it was up 424%.

The 152-year record of U.S. market returns is littered with bear markets; in each case, the market eventually recovered and went on to new heights. If history is any guide, prudent long-term investors who can withstand the risks of equity investing should stay the course and not panic. Eventually, they will be richly compensated.

  1. The standard bell curve is an inadequate model of stock market returns.

One reason the risks and potential awards of equity investing are often misunderstood is that standard models of equity returns are based on the bell curve. A model that can capture the extreme risks of the equity market (its “fat tails”) is needed.

In a bell-curve model, it is virtually impossible for there to be the sort of extreme returns that are largely responsible for the deep declines and large runups that we see in market history. In other words, bell-curve models lack the fat tails (the extreme returns on the ends of the curve) that we see in historical returns.

This has been covered in detail in Where Risk Models can miss the mark.

  1. Extreme events are not that unique.

Just look at history.

The Great Depression, World War II, Cuban Missile crisis, the Asian financial crisis, dotcom meltdown, the India-Pakistan and India-China stand-offs and border skirmishes at various times, the 9/11 terrorist attacks on the Twin Towers in New York, war in Iraq, the Russian-Ukraine aggression, the Global Financial Crisis, the European debt debacle, trade sanctions in the battle between U.S. and China, the pandemic.

It is not a smooth ride. There are extreme events and frightening crashes. But the trajectory has been upwards. The regularity of market crashes and declines is a reminder that patience is key to investing in equity markets.

The above information has been extracted from these articles by Paul Kaplan:

What prior Market Crashes taught us in 2020

In the history of Market Crashes, Coronavirus Crash was the shortest

6 things to know about Market Crashes and Downturns

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ninan joseph
Aug 7 2022 12:39 PM
Another point from my experience. Do sell a portion of your stocks when the market hits an all time high. If you do not sell, there is only notional profit and nothing else. I am talking here about individual stocks and not funds. If you dont sell a portion, your average cost will never come down and when a black swan event happen, your entire capital will be eroded. Sell a portion when the market hits high or stock hits 52 period high and buy back when there is a correction.
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