Why Markets Will Always Crash

Get used to it.

Mar 31, 2014 at 11:28AM

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.

Contact Morgan Housel at mhousel@fool.com The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers