Stock price crashes cause a lot of human misery. I participated on investment discussion boards when prices crashed in 2008, and many investors were beside themselves in anguish over the losses they suffered. Years or, in some cases, decades of savings were wiped out in a matter of days.
When people suffer that sort of pain as the result of a hurricane or some other sort of natural disaster, the widespread human response is one of empathy. We want to help out people in trouble. That was not the common reaction of the people who suffered huge stock losses. Some offered a small bit of compassion. Sometimes, I heard a bit of victim-blaming. People would say: “You should be prepared for stock crashes; you shouldn’t have money in stocks that you cannot afford to lose in the short term.”
I don’t know. It’s certainly true that people need to be aware that there are risks associated with being heavily invested in stocks. However, it is my belief that those risks are frequently downplayed by people who claim to possess a good deal of expertise in the field. Buy-and-holders say all the time that the market always recovers (which in a technical sense is true – what they leave out is that it can take a long time for the market to recover from a crash that takes place at a time of super high valuations). It’s easy for the average investor to get caught up in the emotion of a bull market and go with a higher stock allocation than is appropriate for him or her. Rarely do people in this field implore investors to take valuations into consideration when setting their stock allocation, a practice that I believe should be universal.
So people suffer pain and are essentially told to “suck it up.” I find this offensive.
This happens because there is still a widespread belief in an understanding of how the stock market works that became popular before Robert Shiller published his Nobel-prize-winning research showing that valuations affect long-term returns. I believe that Shiller’s research will eventually change our understanding of how stock investing works fundamentally. Specifically, it will change our view of what causes price crashes.
The Buy-and-Hold Model posits that stock price changes are determined by changes in economic realities. Of course, we have no means of knowing which way the economic winds will blow, so price changes come as a surprise. There are happy surprises on the upside and discouraging surprises on the downside.
Those days are over!
Shiller showed that it is not economic developments that are the primary determinants of price changes but shifts in investor emotion. When investors generate mountains of irrational exuberance, price crashes follow. It’s not possible to identify the precise time when they will take place. But we can say with certainty that they will. Stock prices do not climb to the moon and then remain there indefinitely. They climb to the moon and then eventually fall sickeningly back to earth when investors lose confidence in the pretend gains that they have created for themselves.
This is good news! I understand that it doesn’t sound like good news. Discussions of price crashes are a dreary business. But Shiller’s discovery of irrational exuberance puts price crashes in an entirely different light that I believe will, in time, come to change our reaction to the pain suffered by investors caught up in them.
Price crashes are optional! That is what Shiller is saying when he says that valuations affect long-term returns. There is nothing in the nature of the stock market that requires that it produce price crashes. They are just something that happens when too much irrational exuberance is generated.
We investors control how much irrational exuberance is generated. So we can control whether price crashes happen or not. Price crashes are not the product of bad luck. They are the product of bad behavior. Any time Buy-and-hold strategies, strategies that say that valuation-based market timing is not required, become popular, price crashes are sure to follow. Once investors stop practicing price discipline when buying stocks, the only way that the market can get prices back to where they belong is by crashing them. It’s not the market’s fault. It’s our fault for not permitting the market to function naturally (price discipline is an essential element of any functioning market).
Price crashes are avoidable. And every market participant has a responsibility to do his part to prevent them by encouraging price discipline on the part of all investors. We shouldn’t shrug our shoulders when we see friends suffer terrible losses in price crashes. We should use the painful experience as an opportunity for learning. We all have that Get Rich Quick impulse within us that makes us want to believe that this will be the first time in history when a Buy-and-Hold strategy (a strategy in which investors stick to their high stock allocations even when prices reach scary levels) will not end in tears for millions. It has never happened because it never can happen. Price discipline is what permits the market to work smoothly. Market timing is an essential part of any sensible stock investment strategy.
