What Second World War airplane crashes teach us about the current state of the stock market

Let’s start this one with a story.

The Second World War was on and the British Royal Air Force (RAF) was facing an unusual challenge. To protect its fighter jets from gunfire by German fighter planes and anti-aircraft guns, it needed to reinforce them with heavy plating. However, because the plating added weight, it had to be used strategically in areas most vulnerable to attack.

In order to do that they had to figure out the areas of the plane that were the most vulnerable to an attack. Jordan Ellenberg discusses this in How Not to Be Wrong: The Hidden Maths of Everyday Life: “The damage [of the German bullets] wasn’t uniformly distributed across the [British] aircraft. There were more bullet holes in the fuselage, not so many in the engines.”

If only the evidence on offer had been taken into consideration, this data seemed to indicate that the fuselage was more frequently targeted and, therefore, required additional protection.

Thankfully, the British did not rely on this straightforward interpretation. Instead, they turned to statistician Abraham Wald for insight. His key insight was that the evidence on offer was only from planes that managed to survive the attack from German bullets and make it back to British airbases.

But what about the airplanes that did not survive the attack and went down? Where exactly were these airplanes being hit is a question that Wald asked. The trouble was the British did not have data for this and it led to Wald coming to a different conclusion from what could have been concluded from the available data.

As Ellenberg explains: “Wald’s insight was simply to ask: where are the missing holes? The ones that would have been all over the engine casing if the damage had been spread equally all over the plane. The missing bullet holes were on the missing planes. The reason planes were coming back with fewer hits to the engine is that planes that got hit in the engine weren’t coming back.” These planes had crashed.

This made the British look at the situation in a different way and as a result, the air force reinforced the engines instead of the fuselage.

So, what’s the learning from this?

1). Individuals and systems usually think and make decisions based on the evidence that is on offer in front of them at a given point of time. This thinking is also usually based on their limited experiences in their lived lives, which they project forward, assuming that things will continue to be the way they are.

2). The Nobel prize-winning psychologist Daniel Kahneman in his book Thinking, Fast and Slow terms this phenomenon as what you see is all there is (WYSIATI). As he writes: “Information that is not retrieved (even unconsciously) from memory might as well not exist.” Basically, in order to make a decision, the human mind constructs the best possible story based on information it has at any point of time and it does not take into account the information that it does not have. It doesn’t go looking for it.

3). The larger point is that our thinking is usually limited by our experiences, the information our mind has access to, and what we choose to do with it.

1). From March 23, 2020, when stock prices fell big time once investors realised that the Covid pandemic had become a reality, to September 26, 2024, the day the stock market peaked, the NSE 500 total returns index, a good representation of the overall Indian stock market, gave a return of around 37% per year. While calculating returns a total returns index takes dividends given by companies into account as well.

Now, the total number of demat accounts as of March 2020 had stood at 4.09 crore. By September 2024, this number had jumped to 17.54 crore, implying that close to 77% of the demat accounts in existence as of September 2024 end had been opened in four and a half years between March 2020 and September 2024. A similar trend was observed in the case of equity mutual funds as well. The number of folios went from 62.69 million to 147.25 million during the same period.

These new investors had only seen the stock market go up. That was the data and the experience they had access to and betting on that they assumed that the stock market would continue to go up.

The situation is akin to the British Air Force during the Second World War deciding to armor the fuselage of their airplanes rather than the engines, based solely on the available evidence. But they did not do that. They tried to take into account the information they did not have access to and made a decision based on that and reinforced the engines instead.

2). In fact, the Nifty TRI 500 index has data starting from January 1, 1995. Between then and September 26, 2024, it had given a return of around 13% per year. Now, compare this 13% per year return to the 37% per year return it has given since March 23, 2020. Clearly, things were out of whack.

Hence, the 37% per year return was an exception to the rule. But most investors chose not to have access to this information. They ignored it. They only worked with what they had experienced from March 2020 onwards. But things changed post-September and the situation of the airplanes hit by German bullets which had not come back, came to the fore.

3). What needs to be remembered is that returns that one can earn from a stock market are not guaranteed. The compounded annual growth rate that fund managers and money people like to talk about is not fixed. Take the case of the Nifty 500 total returns index between December 2007 and December 2017, a period of 10 years. It gave a return of a little over 7% per year and that’s also a reality.

4). Or take the case of the period between January 1995 and mid-June 2003, the Nifty 500 total returns index, was flat. It didn’t give any return over close to eight and a half years.

The point is that all these possibilities need to be taken into account while investing. The trouble is that retail investors get carried away by the noise in the stock market at any given point of time.

There are too many fund managers and other money people who have an interest in saying that this time it’s different. But as has been proven over and over again that’s just a brilliant marketing slogan that deceives people over and over again.

So, it’s always important to take into account the airplanes that didn’t come back because what you see isn’t all there is. There is usually more. Much more.