Stock Market Crashes Are Always Different But The Result Never Changes
Chapter 30 of The Rational Investor
The rational investor is now available in print and eBook here.
Paid subscribers can get a free digital copy of the book here.
If you enjoy the book or my writing, please consider leaving a review on Amazon.
“This time is different.”
That’s the narrative that dominates the news cycle when the stock market does experience a correction or even a crash.
Those who tell you that this time is different want you to believe that whatever is causing the current market crash will lead to a great depression-style financial catastrophe that will take decades to recover from—if we ever do at all.
As a rational, long-term investor, the unpleasant reality is that you will almost certainly live through at least one major market crash in your lifetime. Any event that with the power to crash the global stock market will be something that is genuinely terrifying. Think of a global pandemic or a financial crisis.
The next market crash will be your greatest test as a rational buy-and-hold investor. When that day comes, and every headline is telling you why “this time is different,” I encourage you to return to this chapter.
As you are about to discover, the cause of every market crash is different, but the result is always the same; long-term index investors are rewarded for having the courage to do nothing when the whole world is screaming SELL!
What happens after a stock market crash?
What does the data and evidence say about stock market crashes? Are they ever really that “different?”
A 2018 paper written by William Goetzmann titled “Negative Bubbles: What Happens After A Crash?” examined over 1,000 stock market crashes across 100 different stock markets from 1692-2015. 1
Consider how extensive this dataset is; 100 global stock markets across 323 years. Compare that to the data the blogger who declares “this time is different” next time we experience a major market crash.
Goetzmann defined a stock market crash as a 50% decline from a previous peak, which is exceedingly rare even by the standard of a market crash. During the great financial crisis, the S&P 500 dropped 46% between October 2007 and March 2009. So, if you are worried about a repeat of the financial crisis, the results of this study should be of great interest.
Goetzmann found that in the year after a stock market crash, the chance of a positive return was 60%. The market was more likely to be positive the year following a crash. The probability of an extremely positive return was much more likely than a second year of extremely negative returns.
In the year following a crash, stock markets were twice as likely to provide a positive 25% return than they were a negative 25% return.
Goetzmann referred to this increased probability of high positive returns following a crash as a “negative bubble.” If it’s the bursting of a bubble that causes market crash, a negative bubble is when the market quickly shoots back up to more normal levels
On average, a market crash prior year was associated with a 14.0% to 18.4% higher return.
Sadly for investors, they were less likely to be in a position to take advantage of negative bubbles because Goetzmann also found that investors were more likely to sell stocks after a crash and reallocate to less risky assets. In doing so, they turn paper losses into real losses and miss out on the rebound that follows a crash.
The legitimately scary narratives that are often associated with market crashes scare investors so much that they buy high and sell low, which is a sure-fire way to destroy wealth.
Rational long-term investors who hold onto their investments after a market crash are the ones who benefit from the negative bubbles that follow.
Interestingly, Goetzmann found that the negative bubble concept only applied to significant market crashes of at least a 50% decline from the previous peak.
Market corrections—declines in the 20+% range but less than 50%— were more likely to have further negative returns in the next year. This is what is called an extended bear market and will be the subject of the next chapter.
The Most popular stories on Making of a Millionaire
Want more articles like this one? Read the most popular articles on Making of a Millionaire right here.
Goetzmann, W. N., & Kim, D. (2018). Negative bubbles: What happens after a crash. European Financial Management, 24(2), 171–191. https://doi.org/10.1111/eufm.12164