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In October 1987 the markets crashed. The New York Times headline called it “Bedlam on Wall St.” The Times of London called it “Wall Street’s blackest hours”. Trading volumes nearly doubled past records as investors stampeded for the exit. Stocks lost almost a quarter of their value after just 7 hours of trading, and the picture globally from London to Tokyo was similar. It sounds horrendous doesn’t it? Clearly, a reason to stash your cash under the mattress rather than risk it all on the capricious markets.
Actually, it turns out that humans aren’t great at perceiving risk. For example, we worry about air travel because crashes are large and memorable media circuses. However car travel is far riskier. A similar thing is true of the stock markets. People worry about stock crashes, they sometimes never invest because of a failure to master this fear. Actually history suggests that staying in cash is generally riskier than the being out of the markets if you’re investing for the long term, say 10 years or more. If you’d invested for just the whole year of 1987 you’d have lost 6% on the year, hardly a disaster. Even if you invested the month before the 1987 crash, you’d only have to wait 2 years until you were making money on your investment once again. Remember this is if you were unlucky enough to invest right before the greatest single day crash in history. It turns out crashes aren’t the disaster they appear, often the markets recover unexpectedly quickly. Though, of course it’s easy to forget this in the blind widespread panic at the time.
Now, let’s look at the data on how frequent crashes actually are. If one assumes that crashes are rapid and severe, then a decline of over 10% for the S&P 500 index in a calendar month would fit the bill. If that’s the case then there are eight examples in the S&P 500 since 1950. That means the chance of a crash in any given month is about 1%. To put it another way, such crashes happen about once a decade. If you are waiting for a crash to occur before entering the market, you could be waiting a while.
Largest S&P 500 Single Month Declines Since 1950
However, a bigger problem for investors than crashes are slow and steady market declines. These are less attention grabbing because these are gradual events, but the market can see successive monthly declines that have the potential to erode your savings in the short term. Historically, these can last anywhere between two and nine months and erode up to 35% of your savings in the worst case. They are also about ten times as common as market crashes on a historical basis, but again less headline grabbing. There is no vivid market in freefall in this situation, it’s more like air hissing out of tire.
However, whether you’re worried about dramatic crashes, or the slower and steadier version, that fear may ultimately cost you money. Over the course of a 10 year period the US market has risen about thirteen times out of fourteen. Now, remember that data includes both the spectacular and memorable crashes and the slow periods of decline. Even with those events, the markets more often than not rise in value if you have a 10 year view. For example, Robert Shiller’s data on the market using his cyclically adjusted price to earnings ratio suggests the market is expensive by historical standards. However, it does not imply it’s going to fall on a 10 year view, it’s just expected to rise somewhat less than in recent history based on his historically based projections.
Now, for those who perceive crashes as a reason not to invest in the markets, let’s look at how cash does an investment. Here we see slow and steady decline due to inflation. Every year prices slowly rise, but the value of a dollar in cash does not. This means that over a 30 year period, with the historic US inflation rate of 2.3% the value of your money would halve, and that’s not a bad outcome for being in cash, it’s simply the average historical result.
So investors should worry less about crashes whether rapid or slow. Instead concentrate on building an effective long term portfolio and remember the risks of being in cash. If you are able to invest with a long term view any crash is likely to be few and far between and history suggests the impact will be short-lived.
The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities. Past performance is not indicative of future results.
