Editor’s note: This article was first published in April 2014; its forecast that the IBEX 35 would reach 15,000 and probably 20,000 points, and the reference to Acciona shares once trading at €250, reflect that time; market levels may have changed since.
An old investor used to say that he knew with 100% accuracy what the stock market would do in the short and medium term, and with 98% probability what it would do in the long term. In the short and medium term, the market is certain to fluctuate. In other words, it will go up and it will go down, not necessarily in that order. In the long term, the stock market almost always tends to rise.
Stock market investors should be prepared for the market to fall at least 10% a year, more than 20% every few years, 30% once or twice a decade and 50% two or three times over the course of your life. This means that probably everyone will live through two or three severe economic downturns. That is why, if you don’t build an investing strategy knowing this in advance, you will probably learn the lesson the most painful way.
But… why does the stock market always fall eventually? It’s a question many people never quite understand, and one that Morgan Housel of Fool.com answers in a very logical way.
There are many theories from economists who have spent years studying how the economy and markets behave. The economist Hyman Minsky spoke of the danger of stock market stability, because stability is destabilising. That runs completely against investors’ intuition, which tends to buy when there are no dangers in sight and calm reigns. In fact, every major crisis has come when volatility indicators were at their lows.
(Read: The 10 commandments of stock market investing)
Suppose the stock market rose 8% every single year. Everyone would know that the market always goes up, and nobody would open a bank deposit, whether at 4% or at 7%. People would feel safe buying shares and forget that equities are variable income (meaning more risk than fixed income). Stability breeds a sense of security, and it is precisely when people feel secure that they take on more risk, such as borrowing more or buying shares at outrageous prices.
So if stocks never crashed and managed to create the perception that they never have accidents, prices would rise to the point of guaranteeing a tremendous accident. A strange but true stock market paradox.
We should remember that investing in the stock market really means buying a stake in a company through its shares. We become shareholders in a company, hoping it will share its profits with us. We expect the company to keep growing, and so we always buy shares at a speculative price (we pay more than the company is worth), hoping that it will increase its sales and profits enough to justify the price we paid for the shares, and that new investors will find it worthwhile to keep buying them.
(Read: It’s not what you buy, it’s what you pay for what you buy)
The economy has its ups and downs and economic models change. When there is an economic setback or a shift in the economic model, many companies fall while others are born. But in that volatility, and in the fear of not knowing which companies will come out stronger, which will never be profitable again and which will disappear, we get the levels of volatility that sometimes knock an index down by as much as 50%.
There are never guarantees
Nassim Taleb said that there are never guarantees in investing, only a perception of guarantees. In the stock market there will always be 14 kinds of unfortunate events present:
- Uncertainty
- Variability
- Imperfection
- Incomplete knowledge
- Chance
- Chaos
- Volatility
- Disorder
- The unknown
- Randomness
- Turmoil
- Stress
- Errors
- Lack of knowledge
These 14 ingredients end up turning up in practically every place and market, and when they do, overpriced shares crash quickly. At other times, the shares that are crashing are a bargain for new buyers. That is why one person’s mistake is another’s opportunity: in the crises where many lose money, others make fortunes, both from the stock market disaster and from the new bull market that follows. Remember that nowadays anyone can make money whether the market falls or rises.
But let’s make a distinction
Saying that the stock market always rises is one thing; saying that a company’s shares always rise is quite another. Let me explain.
One thing I’m very clear about is that the IBEX (Spain’s benchmark index) will reach 15,000 points and probably 20,000. I don’t know when, maybe in 5 years or in 30, but at some point it will. That doesn’t mean Acciona shares will trade at €250 again. I have no idea. Some companies leave the index while others join it, and that is why indices tend to rise: the companies selected to be listed in them are supposedly the most solid ones with the greatest potential.
That is also where the need comes from to choose truly solid companies that have been through several severe economic crises and come out stronger again. Likewise, that is why it’s important to diversify moderately and to draw up an investing strategy that covers every possible scenario.
So you have to invest knowing that at some point shares will crash, because, as Minsky said, the absence of accidents sows the seed of a new accident, and markets always crash. Without exception.
So why do stock markets crash?
Stock market falls are an absolute necessity for generating high returns over the long term. They are not a mistake, and they don’t always mean someone has done something wrong. When stock market returns rise, many other assets fall, and vice versa. And that is a balance that has to be maintained.
Once you are clear that shares always crash, you begin to understand certain decisions, such as selling a company that has risen 800% to buy another that has recently been knocked down 40%.
Of course, as I’ve said on other occasions, we are not Warren Buffett, able to see a storm coming and watch our shares fall 50%. Sometimes, when we see dark clouds on the horizon, it is better to put our money safely out of the storm’s way and get back in when there are signs that the sun is about to come out.
Further reading
- An investing strategy if we expect a market fall: dollar-cost averaging
- 8 ways to commit financial suicide
- 18 truths about investing
Featured image: Associated Press, Public domain, via Wikimedia Commons.
