Updated: Jun 14, 2020
Stock market crashes typically coincide with a recession or other disruptions in the global economy. This causes a lot of investors to make a fear-driven decision to sell stocks.
Selling stocks after the stock market has crashed is the worst decision an investor can make. Investors who sell at the bottom of the market turn paper losses into real losses and miss out on the exceptional gains that historically follow stock market crashes.
This post explains why stock prices can drop so quickly and what tends to happen after stock market crashes.
2020 has been a roller coaster for investors
We are currently experiencing one of the most volatile periods in the history of the stock market.
In just over one month, the S&P 500 has declined in value by 34%.
By contrast, it took nearly 1-year for the S&P 500 to decline by a similar amount from October 2007 to October 2008 during the financial crisis.
The speed at which the market has dropped has been alarming and we do not know when the market will bottom out.
There is enough doom and gloom about the stock market and the economy going around. In this article, I want to focus on the positive and discuss what generally happens after a stock market crash and what that means for long term investors.
Why are prices dropping so fast?
To understand why stock prices have fallen so quickly you need to know the basics about how stocks are priced.
Put in simple terms two primary factors determine the price of any publicly-traded company.
1. The expected future profits of that company.
2. The level of risk associated with those expected profits.
Two companies could have the same expected future profits but have different stock prices.
If investors are more confident in the probability of one company achieving those future profits, that company will trade at a higher stock price because it involves more risk.
Similarly, if investors are less confident in the probability of a company achieving the same future profits it will trade at a lower stock price.
Think of it this way. Let's say I started a soft drink company and I had the same expected profits as Coca-cola or Pepsi. The stock price of my soft drink company would be much lower than Coke or Pepsi. Investors would be much more confident that Coke & Pepsi would achieve those expected future profits and are willing to pay a premium price.
For someone to consider taking the risk on my upstart soft-drink company, they would only do so at a lower price than the safer bets of Coke & Pepsi.
Prices have been dropping so sharply because COVID-19 is driving down expected future profits of nearly every company and increasing risk across the board. Put simply, global pandemics are bad for business.
The market reacts to new information and when the information is this worrisome, prices drop.
Negative bubbles: What happens after market crashes
Now that we understand what drives stock prices, let's look ahead to what we might expect after the COVID-19 pandemic is eventually under control.
I'd encourage you to read this paper in The National Bureau Of Economic Research. In this paper, the researchers studied stock market crashes from over 100 stock global stock markets from the years 1692-2015.
In this dataset, the researchers observed more than 1,000 "stock market crashes" where a market experienced at least a 50% decline in one year.
During these stock market crashes, they found two clear patterns.
Stock prices tended to increase dramatically following crashes
Investors reduced their allocation to stocks
We can interpret from those results that investors were understandably scared when the market dropped so quickly. Many investors then decided to sell at the bottom based on those fears and they missed out on large future gains.
The logical choice for anyone invested in the stock market right now and is afraid is to avoid selling. Selling now will lock in paper losses and turn them into real losses and will mean you are likely to miss out on future gains when markets and the economy rebound.
One thing I hear people repeating lately is that "this time is different". The underlying cause of this market crash, a global pandemic is quite different from any market crash we have seen in most of our lifetimes.
However, there is one historical market crash that has many similarities to what we are experiencing today.
The 1918 pandemic and the 1920 stock market crash
Over 100 years ago the world was dealing with an influenza pandemic that lasted from the spring of 1918 to the spring of 1919. The effects of which were devastating.
40 million lives lost worldwide
675,000 lives lost in the U.S
Young, working-aged men were hit the hardest.
By 1920, the stock market and the economy tanked. We can't say that the pandemic was the sole cause of the 1920 recession but it was certainly a contributing factor. We can safely say this pandemic took a massive toll on the labor market and any retail business. A lot fewer people had the privilege to "work from home" in 1918.
By 1921 the unemployment rate in the U.S hit nearly 12%. But the economy quickly recovered. By 1922 the unemployment fell to 2.4%, one of the lowest rates in history.
What if history repeats itself?
What might the economic cost be if COVID-19 turns out to be as deadly as the 1918 influenza pandemic?
There is no way to know for sure, but we do have an estimate. In 2019, the world bank published a report titled "World at Risk". The report estimated that a pandemic similar to that of 1918 would cost the global economy $3 trillion USD.
Don't get me wrong, that is a huge amount of money. That kind of loss would mean a lot of people would lose their jobs and probably their homes.
However, it is not so terrifying when we contrast the cost of the 2008 financial crisis which caused over $6 trillion worth of damage.
These are scary times. No one knows exactly how this current pandemic will play out or what the long term impacts will be. All we can do is make the most rational decision possible with the information we have available to us today.
We have experienced financial meltdowns in the past. We have even experienced financial meltdowns resulting from a pandemic in the past.
In both the 2008 recession and the 1921 recession a lot of investors sold their stocks when the market was at the bottom. These investors locked in losses while those who stayed invested for the long term were rewarded.
If you're ready to master your money, don't forget to enroll in my video-based personal finance course, "Millionaire In The Making: The 30-Day blueprint" Click here to enroll.
This article is for informational and entertainment purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.