Why Markets Will Always Crash

Markets crash all the time. You should, at minimum, expect stocks to fall at least 10% once a year, 20% once every few years, 30% or more once or twice a decade, and 50% or more once or twice during your lifetime. Those who don't understand this will eventually learn it the hard way.

Someone emailed me last week asking why this is:

I guess my question is, why does it have to be this way? Why is something so sophisticated constantly falling apart and never improving? Why can't stocks just go up around 8% every year?

It's a reasonable question. And there's a good answer.

Economist Hyman Minsky spent his career studying why economies boom and bust. One of his counterintuitive theories is the idea that stability is destabilizing. 

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 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. As Nassim Taleb wrote in his book Antifragile, there are 14 types of unfortunate events that are forever and always present:

  • Uncertainty
  • Variability
  • Imperfect
  • Incomplete knowledge
  • Chance
  • Chaos
  • Volatility
  • Disorder
  • Unknown
  • Randomness
  • Turmoil
  • Stressor
  • Error
  • Unknowledge

These 14 things will always occur, basically everywhere. When they occur, stocks that were erroneously priced for "guaranteed" returns quickly crash.

So, here's the weird paradox: If stocks never crashed -- or if they gain the perception that they don't crash -- prices would rise to the point where a new crash was guaranteed.

This sounds crazy, but it's exactly what Minsky meant when he theorized that stability is destabilizing. Since a lack of crashes plants the seeds of a new crash, markets will always crash, without exception. 

What's important is realizing that stock market crashes aren't a bug. They don't indicate that anything is broken, or that someone screwed up. They are, in fact, an absolutely necessity to generating high long-term returns. Without crashes, you will never receive returns higher than other assets that don't crash, like cash in the bank. "Volatility scares enough people out of the market to generate superior returns for those who stay in," Wharton professor Jeremy Siegel said a few years ago. Or as Charlie Munger put it:

You can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century, you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament to be more philosophical about these market fluctuations.

Rather than wondering if we're going to have another crash, spend your time planning how you'll react to a crash when it inevitably comes. Mentally prepare yourself, have some cash, and never rely on short-term market gains to finance your lifestyle. Because, just wait. A new crash will happen. 

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.


Read/Post Comments (21) | Recommend This Article (63)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 31, 2014, at 7:30 PM, kyleleeh wrote:

    This is why I always thought we have ups and downs:

    “All of humanity's problems stem from man's inability to sit quietly in a room alone.”

    ― Blaise Pascal,

  • Report this Comment On March 31, 2014, at 10:07 PM, irvingfisher wrote:

    Didn't anybody go to the bathroom in Pascal's day?

  • Report this Comment On March 31, 2014, at 10:30 PM, JadedFoolalex wrote:

    irvingfisher,

    Yes, they did but it was never quiet!

  • Report this Comment On April 01, 2014, at 3:26 AM, Interventizio wrote:

    I need to read articles like this once in a while to remind myself that I have to be strong when bad s**t in the stock market happens.

  • Report this Comment On April 01, 2014, at 12:26 PM, Mega wrote:

    "I guess my question is, why does it have to be this way? Why is something so sophisticated constantly falling apart and never improving? Why can't stocks just go up around 8% every year?"

    First, the financial markets are extremely complex but that doesn't mean they are sophisticated. There are a lot of dumb people doing dumb things.

    Second, in some ways they have improved substantially over the past few decades. Just not in terms of volatility reduction. High volatility appears to be an inherent trait of markets, flowing from human psychology.

  • Report this Comment On April 01, 2014, at 1:59 PM, mtprx wrote:

    @TMFhousel

    Why isn't overconfidence included on the list. It seems to me that this one word affects pro's and amateurs equally after all when the market goes down isn't everyone affected to some degree? Those who can stay in fair much better than those who withdraw at the low points. It's only human nature to take credit for the wins and blame something else for the losses. Oh my aching bracket.

  • Report this Comment On April 01, 2014, at 8:54 PM, salbergs wrote:

    Despite Hollywood and Michael Douglas, greed is not good and the short minded chasing the fast buck will lose in the end. While being a new Fool, I am a 3rd Generation investor that benefited from the wisdom of my Grandfather who started with nothing along Route 66.

  • Report this Comment On April 02, 2014, at 6:49 AM, Mathman6577 wrote:

    Don't put all your eggs in one basket and have more than one basket.

  • Report this Comment On April 02, 2014, at 9:28 AM, damilkman wrote:

    Here is the rub in my opinion. Look at the statement "never rely on short-term market gains to finance your lifestyle" We invest so that we can retire. In the good old days we would shift our investments from stocks to bonds. However, bonds have such a crummy return you can't afford to live off them. Thus you have to either stay in stocks longer or have stocks be a higher percentage of your total investment.

    I am wondering how much additional volatility is being injected into the system because markets are being warped by low interest rates.

  • Report this Comment On April 02, 2014, at 11:36 AM, wolfman225 wrote:

    You omitted from your list "Government intervention in the Free Market", "Government intervention in enforcing (or not) Contract Law", "Government intervention in all sectors of the economy via Top Down Mandates", etc.

    Laissez-faire is the ultimate solution, though it will likely take decades of education to counter the Progressive indoctrination of a nation in the ideology that everyone somehow "deserves" everything.

    The only thing worse than the free market picking "winners and losers" via a process of free trade, freedom of association, and voluntary contracts is the government picking "winners and losers" via patronage, crony capitalism, and political favoritism.

  • Report this Comment On April 02, 2014, at 11:52 AM, TopAustrianFool wrote:

    Boom and Bust Cycle all done by the Fed.

    1) Fed increases money supply by a number of activities. Artificially low interest rates, de facto reduction of bank deposit requirements, ect.

    2) Capital companies increase production and investments becomes malinvested. Since the low interest rates are not really an indication of savings now and spend later but an illusion.

    3) Fed panics due to inflation indicators and reduces money supply.

    4) Prices drop and malinvested projects do not pan out as profitable with the new prices and costs.

    5) Lay off and bankruptcy follow. This sets up a liquidation period we cal Bust, Crash, etc.

  • Report this Comment On April 02, 2014, at 11:53 AM, TopAustrianFool wrote:

    Morgan,

    I wonder if you wrote similar columns when Bush was president and the crash happened.

  • Report this Comment On April 02, 2014, at 3:09 PM, Mathman6577 wrote:

    @ damilkman: There is a good articel in today's (4/2/14) Wall Street Journal that discusses the effect of low interest rates on the economy and how the rates are influencing how companies deploy their capital instead of hiring more staff. This could be one of the reasons that many people have been unemployed for long periods of time.

  • Report this Comment On April 02, 2014, at 5:58 PM, jolcath2001 wrote:

    Morgan:

    Congrats on this article appearing on the front-page of usatoday.com.

    Has TMF and USA Today always been a partner?

  • Report this Comment On April 03, 2014, at 8:52 AM, XXF wrote:

    Morgan, being occasionally critical of your pieces I wanted to take an opportunity to let you know this one was great. Fool on.

  • Report this Comment On April 03, 2014, at 4:58 PM, chairmanwow wrote:

    "assets that don't crash, like cash in the bank"

    But see: http://static.seekingalpha.com/uploads/2009/5/8/saupload_pur...

    Maybe not a crash; more of a long, slow collapse.

  • Report this Comment On April 03, 2014, at 8:59 PM, Sanfordbee wrote:

    Yeah, definitely needed this. I'm down more than 10% on some recent SA recommendations. It's nice to remember that I got into this only a few months ago thinking I had what it took to stomach some rough patches, but I got kinda sheepish once I started seeing so much red on my scorecard. I suppose I just gotta stop picking at it and let it heal.

  • Report this Comment On April 04, 2014, at 6:32 AM, KBecks wrote:

    This reminds me of forest fires making room for new growth.

  • Report this Comment On April 04, 2014, at 7:34 AM, Tomohawk52 wrote:

    Fantastic article and funny, insightful comments above. I assume the same applies to other markets, for example the housing market?

  • Report this Comment On April 04, 2014, at 6:14 PM, drborst wrote:

    Morgan, This is close to your best work...

    But that Munger quote... If I had 5% of his net worth, I could react with equanimity to a market decline of 50%. And I was even able to react to the 50% decline I saw in 2008 with equanimity. But if it happens in 2021, 2024, or after 2030 (when child #1, and #2 go to college, and when I hope to retire), then not so much.

    So should I move to bonds and accept mediocre returns around then (or should I keep working with equanimity?)

    DRB

  • Report this Comment On April 28, 2014, at 5:34 PM, lisalisarose wrote:

    I simply love this article. It's so important to think of this as par for the course instead of the end of the world.

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