Lesson 10 of 42: Stock Market Crashes: Why Markets Decline & How to Survive

 

For some investors, stock market crashes are like the bogeyman.

They're terrified the monster is always lurking just around the corner. 

In this lesson, we're going to shine a light on the stock market crash "bogeyman" and take a good look at him.

Let’s understand why stock markets crash and how you can survive (and even profit) from a market sell-off.

What is a Stock Market Crash?

First of all, let’s step back and understand what exactly constitutes a stock market crash and what doesn’t.

Some investors are quick to call any market decline a “market crash,” which isn’t accurate.

There are actually three different levels of market decline, as shown in this table from AE Wealth Management

All of these declines are measured from the market's recent high to its lowest low: 

  • Pullback / Dip: A market “pullback” or “dip” is a short-term downturn after a broad longer-term uptrend. In a pullback, the market may decline anywhere from 5% - 9%. Sell-offs of less than 5% are generally considered the normal oscillations of the stock market.
  • Correction: A correction is a decline between 10% - 19% from a recent market high.
  • Bear Market: A bear market is a 20% decline from recent market highs. It's usually a sustained downtrend in several major stock market indexes that lasts months or years.

And finally, there’s a “stock market crash,” which is a large and fast decline in stock prices that occurs over a period of just a few days or weeks. Crashes are usually accompanied by investor panic, such as when The Dow Jones Industrial Average (DJIA) fell 23% in a single day during Black Monday (October 19, 1987).

As a side note, it's possible that sudden stock market crashes driven by panic selling may be slightly less likely to happen going forward.

After the 23% crash in 1987, the Securities and Exchange Commission (SEC) put in place a series of “circuit breakers” that automatically halt trading on the entire stock market or on individual stocks if panic selling occurs.

While circuit breakers probably won’t reduce the eventual depth of the market’s decline, they may help reduce panic selling and curb sudden sharp crashes in stock prices.

What Causes a Stock Market Crash?

There are many things that can cause stock market pullbacks, corrections, bear markets, or outright crashes.

We’ve pulled together a list of the common causes below, but there could definitely be more.

One thing to keep in mind is that stock market crashes and deep bear markets are often caused by a combination of some fundamental economic disturbance that's compounded by an emotional human reaction.

  • Irrational Euphoria: Investors can experience irrational euphoria and bid up the prices of stocks (and other assets) to levels that are disconnected from reality. Once “the music stops” and everyone sees reality, prices can come crashing back down to earth.
  • Speculation / Asset Bubbles: Similar to euphoria, investors can become highly speculative and make investments (often fueled by borrowing debt) well in excess of reason or their ability to repay.
  • Geopolitical Events: Unexpected high-impact events such as natural disasters, terrorism, wars, or plagues can cause instability in markets.
  • Slowing / Shrinking Economy: An unhealthy underlying economy can drag down many different businesses as well as consumer and investor sentiment.
  • Overstretched Valuations: Bull markets that run too far, stretching valuations beyond reason, can set the market up for a period of extended decline.
  • Too Much Debt: Excessive borrowing can cause bubbles, euphoria, and stretched valuations in many different areas of the economy. Looking back at history, corporations, governments, and consumers have all been guilty of taking on more debt than they could handle. When it comes time to pay back borrowed money, defaults on debt can cause markets to plummet.
  • Trading Algorithms: Trading in stock markets is increasingly driven by computer-based algorithms that automatically make trading decisions and execute trades in under seconds. If many of these algorithms react to the same market signals and decide to systematically sell at the same time, it can cause fast declines in the market.
  • Consumer Panic / Loss of Faith: If consumers lose faith in the government, currencies, banks, or other major institutions it can cause panic to spread to the stock market.

These are just a handful examples. We’ll cover many more potential stock market risks in our next lesson.

So, while the above list covers many hypothetical causes of market declines, let’s look at this table from Duff & Phelps which shows the largest declines in U.S. history from 1870 - 2015:

Each market decline tends to look different, making it difficult to anticipate and plan for. 

Some of these declines are enormous, including the 54% decline in 2009. Having lived through that bear market, there were moments where it felt like we’d never recover.

But to really understand crashes, corrections, and bear markets, it’s important to zoom out and look at the full history.

Some Stock Market Declines Are Healthy and Normal

Some investors have a tendency to dread and bemoan any decline in stock prices as if something has gone wrong or the market has failed to live up to its promise of reliable profits.

While the market has consistently delivered incredible profits over the last 100+ years, there have been many pullbacks (5% - 9% declines), corrections (10% - 19% declines), and even bear markets (20%+ declines) that are a healthy part of the long-term growth of our economy.

To be clear, we’re not saying every bear market is a normal event that investors should welcome. Many were driven by massive underlying problems in the market, economy, country, and world.

But some stock market declines are normal and not every decline is a “stock market crash.”

Looking at this chart from American Century Investments, we can see there have actually been many bear markets and corrections throughout history.

And despite all those declines, the market has kept marching upwards.

Here’s another way to look at it.

Raymond James shows that since 1980, drops in the market within any given year are pretty common.

For example, look at the first bar on the left for the year 1980. They’re saying the S&P 500 returned a strong 26% that year, yet suffered a 17% decline at some point during the year.

The point is stock market declines are normal.

Yes, they're brutally painful when they're happening. And yes, they can be devastating to your wealth.

Some are long and some are short. But overall, looking at 10 - 15 year periods of time, the market has tended to recover and then some.

Which brings us to our next very important point.

The Power of Stock Market Recoveries

When the market sells off hard in a correction or bear market, it has a tendency to rally just as hard afterward.

For example, look at this chart from Fidelity which shows the incredible triple-digit returns in the market after several painful bear markets.

Similarly, this table from American Century Investments shows the 1-year, 5-year, and 10-year recoveries after several market downturns.

One thing to note, this table doesn’t include dividends. If dividends were included the declines they report would be smaller and the returns would be bigger.

There are a few important takeaways from this table:

  • The average downturn lasted 21 months (just under two years).
  • The average downturn decline was roughly 40% from market peak to trough.
  • The average return one year into the recovery was 47%.
  • The average return five years into the recovery was 109%.
  • The average return 10 years into the recovery was 195%.
  • Remember, all figures are excluding dividends, which would boost returns further. 

This underscores two very important points:

  1. When markets decline hard, they’re often set up to recover and deliver a large return in the following years.
  2. If you had bought more shares towards the bottom of historical downturns (or more likely, bought steadily throughout the downturn), you would've realized tremendous returns over the following years.

Deep market sell-offs can act almost like an overstretched rubber band that snaps back into place, driving a fast and strong recovery. 

We’ll discuss the importance of investing through a crash much more in a moment.

But first, let’s look at what you should do if the stock market starts to crash.

How to Survive a Stock Market Crash

Let’s cover a few insights on how to handle a stock market selloff.

But before we do, we have an important note about something you can do today to better ensure you can survive a potential bear market in the future.

Never invest money in the stock market that you’ll need to use soon.

There’s a general guideline that you shouldn’t invest money in the market that you'll need in the next 5-10 years.

The idea is that if there’s a deep market decline, it will almost certainly recover over the next 10 years. But if you needed the money you invested for something (say, your children’s education, retirement, or mortgage payments), it may not be there for you while the market is still in decline.

Let's sum it up with a famous stock market saying: “The market can remain irrational longer than you can remain solvent.”

Now, here’s how to handle a big stock market selloff:

Don’t Panic

First off, try not to panic.

It’s important to keep a level head and evaluate your investments, financial goals, and personal risk tolerance with a clear, analytical mind.

You may have to fight your instincts and tap into your logical mind.

If you decide to stay invested, that’s fine. If you decide to buy more stocks, that’s fine. And if you decide to sell everything, that's OK too.

Just make sure whatever decision you make comes from a place of thoughtful logic rather than reactive panic.

Be Patient

Remember that it will take time for markets to recover. And the process will be emotionally and financially painful.

While there’s nothing you can do to speed up the recovery, there are smart decisions you can make today that will pay off tomorrow.

If your future self from 10 years in the future could give you investing advice today, history suggests he'd probably say, “Stay calm. It works out. Buy more.”

Turn Off CNBC

The news media goes into a frenzy when markets sell off.

They fuel investor fears in order to boost how many people consume their content. Do your best to tune out their noise so you can keep a level head and make smart decisions. 

Now, we’re not suggesting you bury your head in the sand and pretend nothing is happening. But don’t watch the talking heads on financial TV all day and hyper-analyze the market’s every movement.

Stay Diversified

You should always be well diversified when investing in stocks, but this is especially true during a bear market.

If you were to over-concentrate in any one area of the market, you could become overexposed to risks particular to that area.

For example, imagine all you owned were 10 bank stocks right before the Global Financial Crisis in 2008. You’d be devastated.

You should always be diversified. But a market sell-off is a good chance to double check.

Get Defensive

Depending on your investing style and goals, a market sell-off could be a good opportunity to shift towards a more defensive investing strategy.

Maybe you want to move out of small cap stocks or high growth stocks and into dividend stocks, index funds, or even bonds?

It will be a personal decision. Just make sure you decide from a place of careful logic and not a panicked flight from the stock market because it’s selling off.

Buy the Best Stocks

You should always want to own the best stocks possible, regardless of market environment. And this is especially true during a market downturn.

As markets decline, companies will continue to report earnings on a quarterly basis. This is a huge opportunity for you to see how different companies and industries are handling the downturn.

If one of your stocks seems to really be suffering, with sales and earnings in rapid decline, maybe you should consider finding a company that’s weathering the storm better.

Our research suggests all stocks tend to get caught up in a market sell-off, but the best high-quality stocks tend to recover faster and higher than the rest of the market

We'll show you several powerful examples below.

Don’t Try to Time the Market

Trying to time the market (for example, selling everything because you expect an imminent downturn and then jumping back in because you expect an imminent rally) is a bad strategy.

We discuss timing the market in complete detail in our article, “Should I Sell Everything Now to Avoid a Stock Market Crash?

But we’ll provide a brief recap here:

Research suggests it’s very difficult for investors to correctly time the market.

And when they try, it often comes at a high cost: missing out on big gains.

Interestingly, the majority of the stock market’s gains happen during very short periods of time. Market profits aren't evenly distributed throughout time.

In fact, the Cogent Advisor shows that since 1927, just 8.5% of the months have provided nearly 100% of the stock market’s returns.

If you were to miss some of the best months while trying to time the market, your returns could take a massive hit.

Let’s look at an example from Morningstar:

Their chart shows the effect of missing out on the single best month of returns each year, but being invested in the market for the other eleven months of the year.

The results are amazing. Just one month each year appears to be responsible for a huge portion of the total annual returns.

And in some years, if you skip the best month your returns swing from positive to negative.

The point is clear:

If you try and time the market by jumping out until things “settle down,” you risk missing out on a huge portion of returns.

Calamos provides a similar analysis on the cost of missing the best days over the last 20 years.

They show that missing just the 10 best days over the last 20 years would cut your annual returns in half.

And if you happened to miss the 30 best days over the past 20 years, your investment of $10,000 would've turned into $9,026 (a loss of nearly $1,000) rather than quadrupled to $43,930.

Now, keep in mind those “best days” aren’t all right in a row, they’re distributed throughout the 20 year period. So it’s unlikely you could miss them all by jumping in and out of the market even if you tried.

But the point remains the same:

Historically, stock market returns have been concentrated in small spurts of high performance.

If you try to outsmart the market by jumping in and out you risk missing these periods of high returns and greatly diminishing your long-term profits.

So, what should you do instead?

In our experience, during a big market sell-off it’s best to keep investing in the market, steadily buying up shares of high-quality companies that are deeply undervalued.

If you can keep your head, you may have a chance to go on a shopping spree where all your favorite stocks are 50% off.

Warren Buffett has a quote that sums it up nicely: “Be fearful when others are greedy and greedy when others are fearful."

How to Profit By Investing During a Market Decline

Put simply, investing through a market downturn allows you to buy shares of high-quality companies at discount prices and ride the market recovery for strong returns.

Let’s walk through an example.

Let’s pretend you invest $10,000 into the stock market today and due to very bad luck, today happens to be the absolute peak of a bull market. Literally you put your money in on the worst possible day.

Sadly, the market turns sour and one year later your investment has declined a devastating 50%. Your $10,000 is now $5,000.

Now, let’s pretend over the next five years the market recovers by rallying 100%. That’s great! A 100% rally is double the 50% decline, right?

Well, not quite. 

Because the amount of money you invested was reduced by 50% during the selloff, that 100% rally brings your $5,000 up to $10,000, which is exactly where you started.

So, in this scenario the market declined and then rallied by twice as much, but you’re just back to where you started.

You didn’t lose money (which is good), but you also kind of lost all that time because your money didn’t grow at all.

Now, let’s look at what happens instead if you were to continue investing through the downturn.

Again, imagine you invest $10,000 in the market today, there is a deep bear market sell-off of 50%, and your $10,000 is now worth just $5,000.

But this time, during the depths of the bear market you take a deep breath, remember reading this lesson, and invest another $10,000 into the market.

So now you have $15,000 invested in the market: the $10,000 you just put in and $5,000 from your previous investment, which got cut in half.

Just like above, the market rallies 100% over the next five years and this time you now have $30,000 - that’s triple your original investment!

Seems like black magic math, doesn’t it?

The 100% rally turned the $5,000 that got halved back into $10,000 (just like in the first scenario), but it turned your new $10,000 investment into $20,000. 

So your total investment of $20,000 is now worth $30,000 (a 50% return), whereas in the first scenario your total investment of $10,000 became worth just $10,000 (a 0% return). 

The specific numbers don't really matter. What matters is the takeaway:

The magic comes from the fact you put more money into the market at its bottom, right before it rallied.

Rather than just breaking even through the decline and recovery, you were able to earn a 50% profit. 

Now, we’re not suggesting you wait and try to time the absolute lowest moment of the market. Research suggests that’s just as hard as trying to time the top of the market.

But the lesson is critically important:

If you’re a long-term investor and the market sells off hard, it presents a tremendous opportunity to buy high-quality stocks at bargain basement prices.

Let’s look at a real-life example to try and imagine what a market sell-off might feel like and how you can collect huge long-term profits.

Why You Should Buy Stocks “When Others Are Fearful"

In October of 2007, the stock market peaked and began its painful decline as the Global Financial Crisis started to unfold.

Over the next two years, banks like Lehman Brothers and Bear Stearns collapsed, the government scrambled to bail out the banking and auto industries, and panic spread like wildfire through global markets.

Similar to our example above, let’s go back in time and imagine you had the bad luck of buying Apple (AAPL) stock at the absolute peak of the market in October, 2007.

You thought to yourself:

“Apple seems like a great company. Everyone has Apple iPods, that new iPhone seems pretty slick, and Mac computers look like they're making a comeback. I’m going to buy some Apple stock!”

So, in October of 2007 you buy some shares of Apple.

Well, unfortunately for you, your timing was bad luck and the markets (and your new shares of Apple) begin to sell off.

For nearly 18 months, the markets head downward in a painful and panicked tumble.

By March of 2009, the value of both the S&P 500 and your Apple shares are down by more than 50%.

At this point, you're frustrated to see your investment cut in half and nervous it could fall further.

So, what do you do?

You could sell your shares in disgust and take your money out of the market (who could blame you).

Or, you could stay invested and hold on, hoping that the markets eventually recover.

Or, you could sit down and say to yourself:

“You know, when I bought Apple stock about two years ago it was a great company. It’s gotten caught up in this terrible bear market. But based on my research, I still think it’s every bit as good a company today as it was back then. So I’m going to buy more.”

So you double down on your investment and buy more shares of Apple in March of 2009.

What happens next?

As bear markets eventually tend to do, the selling stops and stocks start to recover.

From March, 2009 through November, 2018 your Apple stock rallies an astronomical 1,837%.

The S&P also rallies, but only 393% - nothing compared to your Apple investment.

Here’s what your investment looks like over the full period:

Notice that even if you had just held onto your original shares (which declined 51%), you still would’ve ended up with an 859% return.

But by doubling down and buying more at the market bottom, you were able to earn an incredible 1,837% on that second set of shares - that’s almost an extra 1,000 percentage points for doubling down rather than just holding.

Now, Apple’s stock has done exceptionally well since 2009. Better than many other stocks in the market.

And no one’s timing is as good as the example above.

But it doesn’t need to be.

The point is that you could’ve grabbed more shares in Apple (or any number of other high-quality companies) at many different points during the bear market and earned tremendous profits over the following years.

Here’s Google (GOOGL) stock from the March, 2009 bottom of the market through November, 2018.

And here are a few “boring” but high-quality stocks you could’ve scooped up in a fire sale.

Here's Lowe’s (LOW), delivering a 750% return. 

And Mastercard (MA), for a 1,366% return. 

And finally, Visa (V), with a 1,112% return. 

When the water gets choppy in the stock market, many investors panic and sell off all their shares. It takes a smart and disciplined investor to stay invested.

But to stay invested AND add more money when the markets are in decline, that takes a masterful level of emotional control and long-term vision.

But remember, over time the stock market tends to go up. 

Of course, nothing in investing is guaranteed. Anything can happen.

But based on 100+ years of history, the odds of a recovery after a bear market are overwhelmingly in your favor.

Let’s revisit our chart from American Century Investments.

We see that the the stock market has never had a 15-year period where it failed to return a profit. And it’s delivered a profit in 94% of 10-year periods and 86% of 5-year periods since 1926.

Zooming out, let’s look at a chart from First Trust that maps all the bull markets and bear markets since 1926.

We can see that the bull markets tend to last longer and gain more than the bear markets.

Now, when we talk about investing more during a market downturn, we’re not recommending holding back some cash from the market now in anticipation of a future market downturn and then investing it when things turn south.

That’s the same as timing the market; putting cash on the sidelines and trying to jump in at the perfect moment.

Instead, many investors are able to invest new savings from their job or other sources of income throughout a downturn.

During a market sell-off, try to pick through the chaos and find high-quality companies that are weathering the storm and are well-positioned to rally through a potential recovery.

Ask yourself, "Despite all this market chaos, who has a solid, high-quality business that will prosper when the markets recover?"

Try not to overthink exactly when to buy these high-quality stocks, as market movements during a sell-off can be erratic and nonsensical.

Just keep steadily buying up shares of high-quality stocks at deep discount prices.

Your future self will thank you. 

Stock Market Crashes: Lesson Summary

We covered a lot in this lesson on market crashes. Before we summarize the most important takeaways, we want to make one final point.

Throughout this article, we've tried to shine a light on the stock market crash “bogeyman.”

By walking through historical research, we've tried to take some of the fear and mystery out of stock market crashes and show how deep market declines can act like an overstretched rubber band that snaps back into place, driving a fast and strong recovery. 

That said, we’re definitely not trying to diminish or shrug off bear markets. They’re incredibly painful to live through and can cause serious damage to your financial future.

Stock market declines should be respected and handled with extreme caution. But we’d discourage flat out fear and panic.

Market sell-offs are a natural part of economies and markets and often present an incredible opportunity to buy high-quality stocks at deep discount prices.

So be cautious and disciplined, but don't let fear crowd out your judgment.

Here are the major takeaways from this lesson on stock market crashes:

  1. There are three different levels of stock market decline: Pullbacks (5% - 9% decline), corrections (10% - 19% decline), and bear markets (20%+ decline).
  2. Not every market decline is a “stock market crash,” which is marked by a large sudden decline across several market indexes and widespread investor panic.
  3. Stock market declines have many causes and they tend to manifest in uniquely different ways each time.
  4. Healthy markets regularly experience pullbacks and corrections. Even bear markets are a normal part of long-term economic growth.
  5. After stock market declines, recoveries can provide huge gains over the following one, five, and ten-year periods.
  6. Don't try to time the market. It's very difficult to do well and missing out on just a few days of strong market performance can seriously hurt your long-term returns.
  7. To survive a stock market selloff, don't panic, tune out the noise, stay diversified, carefully analyze your situation, and look for high-quality stocks to buy at discount prices.
  8. Buying high-quality stocks throughout a market decline can provide tremendous profits over the following years.

Next up, we’ll dig into the risks of investing with Lesson 11: What Are the Risks of Investing in Stocks?

This lesson is from our free course, “How to Invest in Stocks: Learn How to Buy Stocks, Make Money, and Avoid Mistakes.

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