6 things to know about stock market crashes and…

Here we go again. From December 2021 to mid-June, the US stock market has fallen about 20% in real terms.

This isn’t the first time I’ve written about major stock market declines, which include articles on the coronavirus crash and market crash history.

Lessons from stock market declines

I’ve seen several themes emerge when it comes to these major stock market declines:

1. Stock markets go through long and deep declines from time to time;

2. After a big drop, it’s hard to predict how long it will take for stock markets to recover;

3. Over the very long term, stock markets have been very generous to investors who can weather long periods of downturns;

4. During periods of rapid and deep declines, investors should avoid panic selling;

5. The standard bell curve is an inadequate model for stock market returns. A model is needed that can capture the extreme risks of the stock market (its “fat tails”);

6. Sometimes the market and the economy move in opposite directions.

How common are crashes?

Let’s take a closer look at these occasional periods of stock market declines.

The chart below uses real monthly US stock market returns since January 1886 and annual returns over the period 1871-85, which I originally compiled for Laurence B. Siegel’s 2009 book, Insights Into the Global Financial Crisis.

By convention, I use the term bear market to refer to a downturn of 20% or more. Each downturn is indicated by a horizontal line beginning at the episode’s cumulative peak and ending when the cumulative value returns to the previous peak.

As you can see in the chart above, the 152-year record US market returns are riddled with bear markets; In any case, the market eventually recovered and reached new heights.

This was last true in 2020. After falling 20% ​​in real terms from December 2019 to March 2020, the US stock market fully recovered in just four months and regained its pre-crash levels in July, soon to push higher.

This market rally is proof of the second lesson about stock market declines: you can never predict how fast a recovery will be.

New highs after market downturns

An investor who has stayed in the market during these extreme downturns has been well rewarded so far.

The chart above shows that despite downturns, some of which were quite long and severe, the US dollar invested in late 1870 rallied to real US$20,514 by the end of May 2022. This corresponds to a real annual return of 6.8%.

Think back to when the market bottomed in February 2009. From then until May 2022, it increased by 424%. Even after the additional drop that took place in the first half of June 2022, making the current drop an official bear market, the market is up 409% since February 2009.

Remember when the market collapsed in January 2020. From then until May 2022, it’s up 18%. Even after the additional drop in the first half of June, the market is up about 14% since January 2020.

Not all dips and rallies are created equal

Below is a list of the 22 worst market declines in the nearly 152-year history of the US stock market.

The table shows the month when the cumulative value peaked before the decline, the month when the stock market decline was at its worst (the bottom), and the month when it reached the previous peak.

Not surprisingly, the biggest drop occurred in the 1929 crash, when the cumulative figure fell 79% and took four and a half years to recover. (That rebound was short-lived. It was followed by a nearly 50% drop, the fifth-biggest drop on our list.)

exhibition 2

More recently, the second largest decline was in the 2000s, at 57.6%. This decade began with a crash, followed by a near recovery, but then experienced another crash – the global financial crisis.

To put things in perspective, note that the 18.3% drop (18th on our list) that began with the outbreak of the novel coronavirus pandemic took just four months to recover, although the pandemic lasted much longer. This shows that the stock market is not the economy.

As of May 2022, the current stock market decline is 17.5%, ranking 21st on our list.

At this point, we do not know how severe this current market decline will be, how long it will last, or how long it will take to recover. But if history is any guide, prudent long-term investors who can withstand the risks of investing in stocks should stay the course.

lessons learned

Of course, at the time of a market crash or downturn, we had no way of knowing this would be the case – which is why some investors panicked and sold their holdings.

It just shows the unpredictability of the markets. Not all crashes are equal in severity and duration, and it is difficult to pinpoint the market’s peak or bottom. Therefore, the best way to prepare for the next crash is now by owning a well-diversified portfolio that fits your time horizon and risk tolerance.

What I wrote more than two years ago rings truer than ever:

“Market risk is about more than just volatility. Market risk also includes the possibility of depressed markets and extreme events. These events can be scary in the short-term, but this analysis shows that for investors who can stay in the market for the long-term, equity markets are down as before rewards for taking those risks.”

Understand the risks

One reason why the risks and potential benefits of investing in stocks are often misunderstood is that standard models for stock returns are based on the bell curve.

In a bell curve model, it’s virtually impossible for there to be the kind of extreme returns that are largely responsible for the deep falls and big rises we see in market history. In other words, bell curve models lack the thick tails (the extreme returns at the ends of the curve) that we see in historical returns.

Understanding the past can help investors weather the current recession. And if this one is like everyone else for the last 150+ years, investors will be richly compensated.

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