A bird's eye view of the history of stock market crashes, over the last 2 decades reveals a broader rhyme and its nuances presents important learnings for all its stakeholders. Read on to find out five lessons we were able to learn from past crashes in the stock market.
1. Patience, always gets rewarded
In the aftermath of a crash, it is human tendency to become impatient as market jitters inevitably prompt investors to sell their stocks as they try to either rebalance their portfolios or 'go full cash out'.
Empirical data (over the past two decades) reveals that we've not only survived crashes, infact, the market has gone on to reach new highs.
There's no certainty of when the next recession is going to occur, or whether markets can continue to deliver acceptable returns in the next year. However, it's a given that the economy will recover from a downturn regardless of how hard the fall is. Therefore, it is important for an investor to continue their search for attractive investment opportunities.
History of stock market crashes, over the last 2 decades
UPA -1 Election , 2004
On 17 May 2004, the BSE fell 15.52% - its largest fall in history (in terms of percentage).
Crash of 2006
On 18 May 2006, the BSE Sensex fell by 826 points to 11,391.
Financial crisis of 2007–2008, the stock markets in India fell on several occasions in 2007 as well as 2008
Crash of 2009
On 6 July 2009, the Sensex fell by 869 points to 14,043.
Crash of 2015
On 6 January 2015, the Sensex fell by 854 points to 26,987.
Crash of 2016- NPAs of Indian banks & global weakness. The stock markets in India continued to fall in 2016. By 16 February 2016, the BSE had seen a fall of 26% over the past eleven months, losing 1607 points in four consecutive days of February.
Crash of 2020- Coronavirus Virus Pandemic
23 March 2020, Sensex lost 3,934.72 points (13.15%) as coronavirus-led lockdowns across the world triggered fears of a recession.
2. Typical pattern of Investor psychology persists across crashes
Behavioural economics theories as posited by Cognitive psychologists Daniel Kahneman and Amos Tversky, the fathers of behavioral economics/finance reveals a rhyme, rhythm that human intelligence is hijacked with overriding emotional behavior.
Some of the pitfalls to be avoided especially against the backdrop of stock market crash are:
- Herd Behavior
Herd behavior represents the preference for individuals to mimic the behaviors or actions of a larger-sized group.
However, in the words of Warren Buffet - “Be fearful when others are greedy and greedy when others are fearful.”
- Overconfidence
While it's important to be confident in your decisions, overconfidence prevents you from having a back up plan and noticing the fine signs that tell you when you exit or enter a specific position in the market.
- Confirmation and Hindsight Biases
Seeing is not necessarily believing as we also have confirmation and hindsight biases. Confirmation bias refers to how people tend to be more attentive to new information that confirms their own preconceived opinions about a subject. The hindsight bias represents how people believe that after the fact, the occurrence of an event was completely obvious.
3. Temptation to ' go all cash" against altered risk- reward scenario
Bear markets can last longer than you think & markets can remain irrational longer than you can remain solvent. In such a scenario, one may have the tendency to " to go all cash" by liquidating one's portfolio. Fewer, would sit tight on the fence waiting for the frenzy to settle.
Empirical evidence indicates that it is prudent to reassess your portfolio and rebalance the assets , equities, gold bonds, real estate, in conjunction with your altered risk- reward profile than to liquidate completely in a rush to move out.
There are no shortcuts to creating wealth and always remember, each one of us is unique and so are our portfolios.
4. Infusion of liquidity by Central banks to stabilise markets and the impending risk of speculation and liquidity trap
Global central banks have pumped in more than $6 trillion into financial markets and reduced interest rates to near zero to tackle the impact of COVID-19 pandemic on the global economy. The RBI has also been proactive in injecting close to ₹10 lakh crore since March 2020.
Given the recent rally in stock markets, domestic & global, there is a clear disconnect between the sharp surge in stock markets and the state of the real economy, as surplus global liquidity was driving up asset prices across the world, posing liquidity trap risk and speculation(read: bubble).
PE multiple for Sensex in the current year at 31.43, the highest since 1998-99 and the Sensex has risen about 25% this year and is one of the best-performing benchmarks among major global markets.
A recent report ( Annual Report 2021) by RBI states a potential risk of a bubble given the disconnect between the steep valuations and underlying fundamentals.
While RBI has expressed concern about inflated stock market prices, the RBI also highlighted several other factors that have contributed to rising share prices including high FPI inflows, sharp rise in direct participation of retail investors and increased activity, resource mobilisation through initial public offers (IPOs), follow-on public offers (FPOs) and rights issues.
On the global front, a look at the Russell 3000 index reveals that 60% of the Growth stocks in the Russell 3000 Index make no money, and this was true even before the COVID-induced recession. Yet, these very companies have been generating huge returns in price movement over the past few years, dramatically outperforming their Value counterparts.
The Russell 3000 Growth Index was up 84% cumulatively over the last two years through August (more than double the return of its Value counterpart).
So investors are making money on companies that make no money – never a good sign as we have witnessed the fall out of such behavior in the late 1990s and in the 2008 speculative bubble.
As Joseph Stiglitz points out (in an article in project-syndicate.org), “today’s excess liquidity may carry a high social cost. Beyond the usual fears about debt and inflation, there is also good reason to worry that the excess cash in banks will be funneled toward financial speculation”, and he warns that this could lead to a “climate of increased (economic) uncertainty” and end up “discouraging both consumption and the investment needed to drive the recovery.” This could lead us into a “liquidity trap”, with a huge increase in the supply of money and not much to show for use of it by businesses and households.
5. Focus on fundamentals, always
Focus on picking winning companies with sound fundamentals. Such companies with their right strategies will invariably figure out how to make money against any external/ internal disruptive event.
"Company fundamentals will rule over any other external factors in determining the value of an equity security in the long term. Understanding this important relationship could help generate alpha returns"