It’s an understatement to say that stocks have been volatile of late. This is what the S&P 500 in the US has done since last Monday:
- 24 Feb 2020: -3.4%
- 25 Feb 2020: -3.0%
- 26 Feb 2020: -0.4%
- 27 Feb 2020: -4.4%
- 28 Feb 2020: -0.8%
- 2 Mar 2020: +4.6%
- 3 Mar 2020: -2.8%
- 4 Mar 2020: 4.2%
And at the time of writing (10:00 pm, 5 Mar 2020 in Singapore), the S&P 500 is down by 2.8%. Deutsche Bank analyst Torsten Slok said last Friday that the speed of the S&P 500’s decline “is historic.” Many are surprised by the ferocity of the recent fall in US stocks.
It’s oh so common
Given the current state of affairs, I think it’s an apt time as any to revisit an important fact about stocks: Declines and volatility are common. I wrote recently:
“Between 1928 and 2013, the S&P 500 has, on average, fallen by 10% once every 11 months; 20% every two years; 30% every decade; and 50% two to three times per century.”
At this point, some of you may be wondering: Why are market crashes so common? This is what I want to discuss in this article too. For an answer, we’ll need to turn to the late Hyman Minsky.
Stability is destabilising
Minsky was an economist. He wasn’t well known when he was alive, but his views on why an economy goes through boom-bust cycles are thought-provoking and gained prominence after the 2008-2009 financial crisis.
In essence, Minsky theorised that for an economy, stability itself is destabilising. I first learnt about him, and how his ideas can be extended to the stock market, a few years ago after coming across a Motley Fool article written by Morgan Housel. Here’s how Housel describes Minsky’s framework:
“Whether it’s stocks not crashing or the economy going a long time without a recession, 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.”
In other words, great fundamentals in the stock market (stability) can cause investors to take risky actions, such as pushing valuations toward the sky or using plenty of leverage. This plants the seeds for a future downturn to come (the creation of instability).
Why bother?
Some of you may now be thinking: if stocks are prone to exhibit boom-bust behaviour, why bother at all with long-term investing? Because of this:
I mentioned earlier that US stocks had frequently crashed from 1928 to 2013. The chart just above shows how the US market performed over the same period after adjusting for dividends and inflation. It turns out that the S&P 500 gained 21,000%, or 6.5% per year. Remember, that’s a 6.5% annual return, after inflation, for 85 years. Sharp short-term declines were seen, but there’s a huge long-term gain at the end.
Then there’s also this:
The US e-commerce giant Amazon (which is in my family’s investment portfolio) was a massive long-term winner from 1997 to 2018, with its share price rising by more than 76,000% from US$1.96 to US$1,501.97. But in the same timeframe, Amazon’s share price also experienced a double-digit top-to-bottom fall in every single year (the declines ranged from 13% to 83%). Again, sharp short-term declines were seen, but there’s a huge long-term gain at the end.
Missing the good times
Here’s another thought some of you may now have (I’m not psychic, trust me!): Why can’t we just side-step all the big downward moves and invest when the clouds have cleared? Wouldn’t this make the whole investing experience more comfortable?
Yes, you may be more comfortable, but you’re very likely going to earn much lower returns.
Dimensional Fund Advisors, a fund management company with more than US$600 billion in assets under management, shared the following stats in an article:
- $1,000 invested in US stocks in 1970 would become $138,908 by August 2019
- Miss just the 25 best days in the market, and the $1,000 would grow to just $32,763
So, missing just a handful of the market’s best days will absolutely decimate our return. Unfortunately, the market’s best and worst days tend to cluster, as seen in the table below from investor Ben Carlson. As a result, it’s practically impossible to side-step the bad days and capture only the good days. To earn good returns in stocks over the long run, we have to accept the inevitable bad times.
Don’t be scared
Markets will crash from time to time. It’s something we have to get used to. Wharton finance professor Jeremy Siegel once said that “volatility scares enough people out of the market to generate superior returns for those who stay in.” So don’t be scared. And please don’t attempt to flit in and out of your shares – patience is what ends up paying in investing.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.