Attention Investors: Market Crashes Are Inevitable

There’s some turmoil in the stock market going on right now with the Straits Times Index (SGX: ^STI) down by 17.5% (as of the time of writing today at 2:15 pm) from its 52-week high of 3,550 points that was reached on 16 April 2015.

In light of that, I thought it’d be good to touch on an interesting and important aspect of the stock market: Crashes are inevitable.

I’ve shared my thoughts on this topic in an earlier article, but let’s go through the main gist of it again. I came to embrace the logic behind this line of thinking due to the work of my colleague, Morgan Housel, who was in turn, inspired by the late economist Hyman Minsky.

Minsky wasn’t particularly well-known while he was alive, but his theories on why economies go through boom-bust cycles are thought-provoking. In essence, Minsky theorized that stability is destabilizing.

Here’s how Morgan describes the main thrust of 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.”

Put another way, great fundamentals in the stock market (stability) can cause investors to pile on the risk, pushing valuations toward the sky and thereby planting the seeds for a future downturn to come (creating instability).

Astute readers may then point something out: If the stock market’s prone to cyclicality, why bother with a long-term buy-and-hold approach (that’s something we champion at the Motley Fool)? The thing is, while a crash may be inevitable from time to time, nobody knows when one will happen.

And, sitting on the sidelines can be harmful for our investing portfolio. Between 1 May 1992 and 18 December 2013, the Straits Times Index had earned an average of 3.48% per year. But if you had just missed the 10 best days, out of more than 5,000 trading days over that timeframe, your annual returns will have become nearly non-existent at 0.12%.

Jeffery Gundlach, a highly successful bond fund manager, once said that “You make 80% of your money in 20% of the time in investing and you have to be patient.” Given what we’ve seen with the Straits Times Index, he seems spot on.

Markets will crash from time to time. It’s something we have to get used to. Just don’t attempt to dance in and out of your shares – like we’ve seen, patience is what pays in investing.

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 doesn’t own shares in any companies mentioned.