What caused the stock market crash, and does it even matter?
Stock prices reflect investors’ expectations about future profits and risk. When expectations change, as they often do, prices change, sometimes dramatically.
Volatile stock prices do not mean the market is broken or the world is ending. Sharp price declines are expected from time to time in an efficient stock market, and their inevitability should be built into every investment plan.
Most people understand this, but there’s a problem: every market drop feels different. People are searching for a narrative, and the narrative can be scarier than the drop itself.
If we understand how a compelling narrative affects our behaviour, we can make better decisions – and feel less anxious – when the stock market declines.
“Narratives are human constructs that are mixtures of fact and emotion and human interest and other extraneous detail that form an impression on the human mind,” economist Robert Shiller explains in his 2017 paper, Narrative Economics.
A narrative does not change the facts of a situation, but it can easily change how people respond to it. The sober reality, though, is that things have tended to work out just fine for a properly diversified investor.
The phenomena of markets bouncing back after crashes was studied in a 2017 paper titled Negative Bubbles: What Happens After a Crash.
The financial economists studied crashes from 101 global stock markets between 1692 and 2015, and identified 1,032 events where a market declined by more than 50 per cent over a 12-month period.
They found that the probability of a large positive return is higher following a crash. Remember, this large empirical data set is immune to any narratives when we observe it.
Each of those crashes were probably accompanied by reasons to expect worse things to come, but we can step back and observe the outcomes, free from the accompanying narratives.
Fundamentally, when stock prices drop, it means expectations for future earnings have decreased, businesses are riskier, or some combination of the two.
To lose all your money in a globally diversified portfolio of stock index funds, we would need to be in a situation where nobody expects any business to earn any profits in the future. This is an extreme case and seems unlikely.
A more realistic bad outcome is having to watch your portfolio decline for a period of time. This is where narratives and asset allocation become equally important. Narratives will make us believe that this time is different – and while the narrative might be different, challenging and uncertain times are nothing new.
Just this century we have seen the dot-com crash, the Sept. 11, 2001, attack on the World Trade Center, SARS, the 2008 global financial crisis and the COVID-19 pandemic. Over the same period, ending July, 2024, the MSCI All Country World Index delivered an annualized return of 5.36 per cent in Canadian dollar terms.
Narratives are powerful and they can change how facts are interpreted. It’s important to step back and look at the broader set of data before responding to an event such as a meaningful decline in stock prices.
Regardless of the narrative, you should be invested in an asset allocation that you can stick with in good times and bad. If a stock market drop has been too painful, it might be a good time to ask yourself if you were taking on too much risk to begin with.
Uncertainty increases risk, driving down asset prices and driving up expected returns. When the market declines, it is not time to get out. This is when equity investors earn the equity risk premium.
On any given day, including after a market drop, the best thing we can do is stick to the plans we made in calmer times.
The economy might deteriorate, but this is why you have an emergency fund. Stocks might continue to drop, but this is why you invest in a risk-appropriate portfolio. When things are uncertain, it can be challenging to make good long-term decisions.
This is why you made a plan, and now is the most important time to stick to it.
