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Investors Take Note: The Stock Market Will Always Crash

Earlier today, I wrote about how volatility in the stock market is a given and that investors would have to endure short-term price declines in order to earn out-sized long-term returns.

I had used Vicom Limited (SGX: V01) and Raffles Medical Group Ltd (SGX: R01) as examples in the article, but the experience of the broader market can also be instructive.

Over the past 12-plus years from April 2002 to end-January 2015, the SPDR STI ETF (SGX: ES3), an exchange-traded fund which tracks Singapore’s market barometer the Straits Times Index (SGX: ^STI), had generated a very respectable total return of some 183%.

That gain though, did not appear as a straight line upward – it came about with sickening volatility. There was even a two-third crash from peak-to-trough during the Great Financial Crisis of 2008-09!

Keeping these examples in mind, here’s an interesting question: Just why would there be periodic crashes in the stock market every now and then despite a steady upward climb over time?

It’s a perplexing question, but economist Hyman Minsky’s theories about how stability breeds instability can provide some answers. Here’s my American colleague Morgan Housel describing Minsky’s ideas:

“Whether it’s stocks not crashing or the economy going a long time without a recessions, stability makes people feel safe. And when people feel safe, they take more risk, like going into debt or buying more stocks.

It pretty much has to be this way. If there was no volatility, and we knew stocks went up 8% every year [the long-run average annual return for the U.S. stock market], the only rational response would be to pay more for them, until they were expensive enough to return less than 8%.

It would be crazy for this not to happen, because no rational person would hold cash in the bank if they were guaranteed a higher return in stocks. If we had a 100% guarantee that stocks would return 8% a year, people would bid prices up until they returned the same amount as FDIC-insured savings accounts, which is about 0%.

But there are no guarantees — only the perception of guarantees. Bad stuff happens, and when stocks are priced for perfection, a mere sniff of bad news will send them plunging.”

Said another way, if stocks never crashed, their prices will reflect such a reality in a paradoxical way that guarantees another crash will come.

So, keep the inevitable occurrence of sharp price declines in mind the next time you want to be an investor in Singapore’s stock market for the long-term. Crashes are not a sign that something is broken or wrong with the economy or the financial markets – it’s simply what’s needed in order for the market to deliver those satisfying long-term gains.

For more investing analyses and important updates about the stock market, sign up to The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Vicom, and Raffles Medical Group.