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

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.

stock crashes

geralt / Pixabay

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.

Get Our Activist Investing Case Study!

Get the entire 10-part series on our in-depth study on activist investing in PDF. Save it to your desktop, read it on your tablet, or print it out to read anywhere! Sign up below!

Q2 hedge fund letters, conference, scoops etc

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.



About the Author

robbennett
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.”