It’s not possible to make sense of stock crashes: Accept it

It’s not possible to make sense of stock crashes: Accept it
geralt / Pixabay

Stock crashes happen from time to time. Everyone gets this. It’s such a widely appreciated reality that we have come to accept it as normal.

I don’t think we should. I view the phenomenon of the stock crash as a very strange reality, and I think that it is a reality that we need to understand better. It is my belief that, if we came to understand stock crashes better, we would not see so many of them.

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Cars crash. That’s also a reality. Our attitude toward car crashes is entirely different from our attitude toward stock crashes. We understand that car crashes are terrible events. So we make an effort to figure out what causes them and then to do what we can to prevent them. We make sure not to drink when driving. And not to speed and not to ignore traffic signs. And to avoid distractions like cell phones.

Can you name one thing that we do to avoid stock crashes? I cannot think of anything. No one likes stock crashes. So we all hope that they will not turn up. But do we know what causes stock crashes? And what acts do we take to prevent them?

Irrational exuberance explained

I believe that crashes are caused by high prices. If high prices are the product of irrational exuberance, then it makes sense that they would cause crashes. If high prices are backed by nothing more than investor emotion, then a large percentage of our wealth is vulnerable to being lost in a price drop. That of course makes us anxious. And it is our anxiety that causes the emotion bubble to pop. So high prices make us vulnerable to crashes, and, the higher prices go, the more vulnerable we become.

How often are investors advised by experts not to drive too fast?

Not too often. The difference between reckless driving and reckless investing is that reckless driving does not provide much of a payoff. Boys in their late teens and early 20s enjoy the “zoom” feeling that comes with driving too fast. But for the most part reckless driving is just stupid and most of us see it as such. So we make serious efforts to avoid car crashes.

But reckless investing offers a big payoff. Reckless investing pushes stock prices up and sends our Pretend Wealth through the roof. For so long as no one reminds us of the stock crash that we are causing, Pretend Wealth feels good. Referring to the coming crash ruins that feeling. So the experts know not to do that.

But do stock crashes make any sense?

They do not. Every day, stock prices go up or down and experts explain why the price change happened. The explanations always provide logical explanations for what happened. Interest rates did such and such and investors responded in such and such a way. But what rational explanation can there be for a price crash? When prices crash, trillions of dollars are lost in a short amount of time. How does that happen? Where does the money go?

The explanation usually given is that investors feared that the economy was heading into a recession. Business profits are obviously less in a recession. So the explanation seems to be on the right track. But it does not entirely hold water. Recessions have been taking place since the first share of stock was offered for sale. So investors know at all times that recessions are a possibility. If something happens that causes a number of investors to anticipate that a recession will come sooner than they had previously expected it to come, that could cause a small adjustment in their understanding of the value of their stock holdings. But the price change should not be as big as what we see when prices crash. Price changes are not a rational phenomenon.

Behavioral perspective of stock crashes

Prices changes are an emotional phenomenon. It is hard to imagine economic developments so catastrophic as to cause trillions of dollars of stock-market value to disappear in a matter of days. But it is not hard to imagine shifts in investor emotion sharp enough to do the job. Stocks are today priced at two times fair value. Investors have persuaded themselves that that is okay. If we were alarmed at the high prices that apply today, the alarm would cause us to sell shares and that would bring prices down. So the very fact that stocks continue to be priced at two times fair value tells us that we find that price level an acceptable one. But a shift in investor emotion could cause half of the value of today’s market to disappear overnight. Logic cannot explain large and sudden reassessments of value, but emotion can.

Robert Shiller's views

Shiller began work on his Nobel-prize-winning research because his wife is a psychologist and he began to wonder what it would mean for stock investing if the belief that investors are 100 percent rational creatures was not well-founded. The answer is that we would sometimes push stock prices up to crazy levels and thereby position ourselves to suffer from the horrible price crashes that would inevitably follow. The encouraging part of the story is that we have Shiller’s research available to us whenever we elect to get about the business of stopping these horrible crashes from taking place.

We can prevent stock crashes in the same way that we already prevent car crashes -- by knowing what causes them and by trying hard to see that the conditions that lead to them are avoided. Stock crashes do not take place because a bad number turns up on the Wheel of Fortune. We cause them. We can stop them.

Rob’s bio is here.

Updated on

Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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  1. Okay, Sammy.

    Lots of people work in their sixties. It’s not exactly a death sentence. I feel a lot better working in my sixties than I would if I sold out my friends and said that I now believe that Greaney included a valuations adjustment in the retirement study posted at his web site. I wish that there was no conflict. I wish that I could say the truth about the Greaney study and that I would be applauded for doing so rather than attacked for it. But I would rather be attacked and work in my sixties than sell out my friends and pretend that I see a valuation adjustment in the study.

    It’s my life and so it’s my choice. Just as it’s your life and so it’s your choice as to the decisions that you make.

    My best wishes to you.


  2. The Greaney issue, which has been addressed with you countless times as to how you are wrong, is merely a diversionary tactic you use. Greaney also has nothing to do with your failed retirement plan. Greaney has nothing to do with your failed predictions. Stop blaming people for your problems.

  3. Wrong again. Everyone can Google your retirement plan, investments and stock crash predictions. The history on each shows massive failure. Of course, like always, you run away from it with your answer by failing to talk about your history. I was actually surprised to see you admit on your own website that you have to go back to work in your 60’s. How about telling the truth here?

  4. My example shows that you CAN time the market. In fact, the entire history of the market shows this.

    Stocks are priced today for a price drop of between 50 percent and 75 percent. Look at where you will stand after such a price drop and you will see that you would have been better off if we had just let stock prices increase each year for the amount of economic growth experienced that year and did not pump it up with any of the irrational exuberance stuff. Phony gains that do not remain in place HURT investors. You don’t have to worry about missing out on that stuff. You WANT to miss out on that stuff. Irrational exuberance is not a plus, it is a minus.

    Irrational exuberance, which Buy-and-Hold encourages, is a poison. When the irrational exuberance disappears (it always does), trillions of dollars of consumer buying power leave the economy. Hundreds of thousands of businesses go belly up. Millions of workers lose their jobs. This is a good thing how?

    We would be better of just reporting the numbers accurately. It is only our Get Rich Quick urge that objects to this. We should be encouraging investors to RESIST their Get Rich Quick urge, not telling them to give in to it.

    That’s my sincere take, in any event.


  5. It’s true that I have been expecting to see prices crash for a long time. And it’s true that it hasn’t happened yet. We don’t disagree on those basic facts.

    We disagree on the idea that this shows that “you can’t time the market.”

    What matters is whether today’s portfolio values are real and lasting or not. I say that they are comprised 50 percent of irrational exuberance. So we know that a crash is coming. No, we do not know precisely when it will hit. But we know with something close to certainty that it will. And that we should be taking that reality into consideration in all of our financial planning.

    If someone smokes three packs of cigarettes per day, can you say precisely when he is going to die from cancer? You cannot. But we can say with certainty that smoking three packs of cigarettes per day is not a good idea. If someone is 150 pounds overweight, can you say precisely when he will have a heart attack? You cannot. But we can say with certainty that it is not a good idea to eat so much that you are 150 pounds overweight.

    You focus relentlessly on the question of whether price crashes can be predicted to the day. I don’t see why it is such a big deal in your mind. If we know that high stock prices cause price crashes and that price crashes cause horrible pain to millions of people, it seems to me that we know all that we need to know to know that we need to do all that we can to keep stock prices at reasonable levels. To me, picking the precise day that a crash is going to come is a parlor trick. It’s such a trivial thing to do that it doesn’t interest me. But being able to avoid crashes by explaining to investors how to practice price discipline when buying stocks (by engaging in market timing!) is a wonderful, wonderful advance, the biggest advance ever seen in this field.

    If we still haven’t seen a crash in the next two years and prices are still as high as they are today I will still be predicting a crash and urging people to sell some stocks, enough to get price back to reasonable levels. And you will still be criticizing me for it. And I will still be not understanding the criticism,

    We see things from different perspectives.


  6. Rob,

    You can’t argue facts. Your own example proves that you can’t time the market. Anyone following your advice would have had a disaster on their hands.

  7. You have been making your predictions of a crash for a very long time. You have been wrong time and again. All you have done is proven you can’t time the market. Despite your continued bashing of buy, hold and rebalance, you have actually provided us a case study in which people would be better off following such a strategy. Despite market corrections, stock have always gone up in the long run. Given your failed retirement strategy, you would think you would have learned by now.

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