Market Crashes (2025 Edition)

Key Concepts

• Market Crashes: Significant and rapid declines in stock prices.
• Investor Expectations: Beliefs about a company's future earnings and risks, which influence stock prices.
• Narratives: Stories that blend fact and emotion, influencing investor behavior and perception during market downturns.
• Risk Premium: The excess return investors expect to receive for taking on the additional risk of investing in stocks compared to less risky assets like bonds or cash.
• Asset Allocation: The strategy of dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash.
• Risk Tolerance: An investor's ability and willingness to withstand potential losses in their investments.
• Risk Composure: An investor's emotional reaction and behavior during market downturns.
• Base Rates: Historical probabilities and outcomes of events, used to inform expectations.
• Financial Plan: A comprehensive strategy for achieving financial goals, including investment plans.

Stock Market Declines: Normalcy and Expectations

Stock market declines are a normal and frequent occurrence in investing. Historical data for US stocks since 1926 shows negative returns in approximately 25% of years. Declines of 20% or more, while less frequent, are not uncommon. Crucially, falling stock prices do not signify a broken market or the end of the world; they are an expected part of investing and should be integrated into any investment plan.

It's important to note that negative intra-year returns do not always predict negative returns for the entire year. Stocks can experience declines during the year and still finish with positive returns. While most investors acknowledge the possibility of market crashes, the emotional experience of living through one is significantly different from observing historical data. Narratives surrounding these events often amplify fear and anxiety, making them feel unique and more severe than abstract price drops.

The Power of Narratives in Market Crashes

Narratives play a fundamental role in market crashes. Unlike the slow-moving nature of economic data, compelling narratives about crises can quickly mobilize investors, leading to rapid and dramatic shifts in asset prices. As described by Yale economist Robert Shiller in his 2017 paper "Narrative Economics," these narratives are "human constructs that are mixtures of fact and emotion and human interest and other extraneous details that form an impression on the human mind."

Narratives can alter how individuals interpret facts and cause them to disregard historical probabilities (base rates) by drawing parallels to familiar past events. While the underlying facts may not change, the narrative significantly influences how people react to those facts. Shiller defines a bubble as a "social epidemic that involves extravagant expectations for the future," and these narratives are often at the core of such phenomena.

Example: The 1920-21 US recession and stock market decline were influenced by a narrative of economic uncertainty stemming from the aftermath of World War I, the lingering effects of the 1918 influenza pandemic, race riots, and growing fear of communism. Similarly, recent events like a global pandemic and trade wars have fueled narratives that make current situations feel unprecedented.

Historical Resilience of Stock Markets

Despite the fear and uncertainty generated by market crashes, stock markets have demonstrated remarkable historical resilience. Global stock returns have been meaningfully positive for at least 125 years, delivering an annualized real return of slightly over 5% (adjusted for inflation in US dollars) from 1900 through 2024. This long history of positive real returns has occurred despite numerous significant global events.

Stocks are inherently risky in the short and long term, which is precisely why they offer positive expected returns and have historically outperformed bonds and cash. This outperformance is known as a risk premium, reflecting the compensation investors receive for enduring the volatility and potential for negative periods.

Historical Context: The early 1900s saw a period of globalization with active stock and bond exchanges in many countries. However, this was followed by a contraction starting with World War I, leading to increased protectionism, tariffs, and the rise of communism and fascism. Some stock markets closed temporarily or permanently. Despite these challenging times, global markets have shown resilience, delivering positive long-term real returns.

Understanding and Managing Risk Tolerance

Market crashes offer a crucial opportunity for investors to understand their true risk tolerance, particularly their "risk composure." This refers to how an investor actually feels and behaves during market downturns. It is essential to self-assess:

• Emotional State: Are you losing sleep?
• Behavioral Reactions: How are you reacting to the declines?

If a portfolio feels more aggressive than anticipated during a downturn, it might indicate that the asset allocation is too risky. Conversely, if an investor in a conservative portfolio with a long time horizon is psychologically comfortable, it might suggest an ability to take on more risk.

The Impact of Price Declines on Expected Returns

When stock prices decline, expected future stock returns tend to increase. From a long-term financial planning perspective, this increase in expected returns can offset some of the effects of the price drop. For investors who continue to contribute to their portfolios during these times, this can be viewed as a positive development. However, investor sentiment often becomes more pessimistic during crashes, driven by narratives rather than the objective increase in expected returns.

Navigating Market Crashes: Practical Advice

1. Revisit Your Financial Plan: Market crashes are a good time to review your financial plan. While plans should be built to withstand volatility, any necessary adjustments should be made sooner rather than later.
2. Stick to Your Asset Allocation: The most effective way to sabotage investment returns is to sell during market downturns. Investors should be invested in an asset allocation they can adhere to in both good and bad times.
3. Avoid Hindsight Bias: It's easy to regret not selling after a drop, but the decision to re-enter the market is far more difficult and costly if made incorrectly.
4. Utilize Emergency Funds: For short-term economic impacts, such as those from tariffs, an emergency fund is crucial.
5. Trust Your Risk-Appropriate Portfolio: For stock market declines, a portfolio aligned with your risk tolerance is the primary defense.
6. Adhere to Your Plan: In moments of uncertainty, it is challenging to make sound long-term decisions. This is why a plan was created during calmer periods, and sticking to it is paramount.

Conclusion: Data Over Narratives

While every market crisis is unique and accompanied by compelling narratives that can influence behavior, it is essential to step back and consider the broad historical data. For hundreds of years, stock markets have demonstrated resilience and delivered positive long-term real returns. By understanding the historical base rates of market behavior and focusing on a risk-appropriate asset allocation, investors can maintain a level head and avoid making costly emotional decisions during periods of market volatility. The key takeaway is to invest in a strategy you can stick with, regardless of the prevailing narrative.