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What to Do When the Market Crashes

A reader writes in, asking:

“I always hear that ‘the market is right and has already factored in all relevant news‘ If that’s the case, then how do you explain times when the market plunged? And if the market was right when it plunged what should I have done? – stayed in the market or pulled my money out also since if the market was right I should also be going with the flow.”

The idea of an efficient market is that it factors all known information into investment prices. But it can’t know the unknowable. That’s why there are big moves (up or down) whenever a big piece of previously unknown information comes to light.

The hypothetical example often used is of a company whose fate depends on the outcome of a court case (e.g., whether or not the court strikes down a patent for their one and only product). If the court rules against them, shares of the company will be worthless. If the court rules in their favor, shares will be worth $100.

If the market estimates that the company has a 50% chance of winning the court case, shares of the company will currently be priced at $50. That’s the “right” price given the known information, despite the fact that the shares will obviously be worth either much more or much less in the very near future.

And the same thing happens at the overall market level. In late 2008, the market’s estimation of the probability that our economy would collapse went up dramatically — so stock prices fell dramatically. Once it became clearer that such an outcome probably wasn’t going to happen (at least not in the immediate future), stocks prices came back up.

Because an efficient market prices in known information so quickly, it only makes big moves in response to new information. In other words, if we assume that our market is efficient, the market’s current price and recent price moves don’t tell us anything about what the market is going to do.* What the market is going to do depends on what new information comes to light — something that’s, by definition, unknown right now.

So What Should We Do About Market Crashes?

When the market crashes, we don’t necessarily know it’s coming back in the near future. It’s possible that it could keep going down. So, how a given investor should respond to a crash depends on the investor’s situation.

  • An investor with a high tolerance for risk (i.e., somebody who can afford to lose the money and who is comfortable with volatility) would rationally choose to rebalance back into stocks (that is, buy more of them).
  • Investors with less risk tolerance might rationally choose a “do nothing” approach. That is, they don’t sell their stocks, but they don’t buy more either.
  • Investors with very low risk tolerance (i.e., investors who cannot afford to lose any more money) could rationally pull their money out of stocks and move it into something safer such as a fixed annuity that promises to pay out regardless of what the stock market does. (Of course, one could make the case that this investor shouldn’t have had so much in stocks to begin with. But that’s a separate discussion.)

*As it turns out, there’s evidence that our market isn’t perfectly efficient in this sense. Over short periods of time, the market tends to exhibit a very slight amount of momentum, meaning that if yesterday was a down day, today is just barely more likely to be a down day. Profiting from this information, however, is rather difficult given how slight the effect is.

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Comments

  1. Great post, Mike. Thanks for being so concise with your “what to do’s” according to one’s tolerance for risk. I’m such a big fan of your blog and books. Keep up the good work!

  2. Chris Forsyth says:

    I am a big believer in the efficient market but there is an aspect to this that has always troubled me. The extent to which “all relevant information” has been factored in must depend on the alertness of all market participants, mustn’t it? For example, at the present time there is a belief by many observers that *quote* money is still on the sidelines *unquote* and that more investors will move money into equities over the coming period. So there is still an opportunity to profit from anticipating this trend by purchasing equities today, i.e. before other investors decide to do so. There is not an unlimited amount of money to be invested by people who may believe as I do, therefore it may not be possible for this information to be fully priced into the current market.

    Another factor in this same vein would be that not all information is possible to price into the market due to the lack of investment vehicles. Consider the lengths that John Paulson had to go to in order to construct his trade against the housing market a few years ago. The average investor, and even many professional investors, would not have been able to invest in the proposition that housing was overvalued, therefore is it not fair to say that the markets expectations about housing were not fully priced in? I guess another way of putting this example is, you can’t short everything you might want to short.

    Thoughts?

  3. Thanks, Mary!

    Chris,

    Regarding your second paragraph, I agree. In the real world there are various constraints that get in the way of perfect market efficiency.

    Regarding your first paragraph, I’m not 100% certain I understand what you are asking for my thoughts on. Are you asking whether such scenarios do occur? Or are you asking whether or not we should call them market inefficiencies?

    If you’re asking about whether or not something should be called an inefficiency, you’ve just hit on an example of what Eugene Fama has called the “joint hypothesis problem.” That is, any time you test for market efficiency, you must also create a model for what an efficient market should look like. If the test shows that the real world doesn’t match the model, there’s no way to know whether a) that means the market is inefficient, or b) your model of market efficiency needs revising.

    In other words, different people have different opinions as to what the market should look like, if it is indeed reflecting all known information at any given time.

  4. Chris Forsyth says:

    Mike,
    You are right to point out that my first question was vague. Part of the problem is that of course “the market” has no meaning as far as being some one thing an investor can invest in. One must narrow and define terms.

    You are also correct of course that one must deal with the joint hypothesis problem. Just because I may believe the market (sorry, let’s say US Equities as reflected in the S&P 500) is lower than it should be, is this because the market is not efficient or just because other investors don’t share my beliefs and expectations. Since I believe in the efficient market hypothesis I would say it is that latter.

    Another way of looking at this is that the willingness of other investors to invest in equities, their risk profiles, their available funds, etc., are all components of the information that must be priced into the market. So answering my own question, the current market valuation levels do in fact incorporate available information about these factors — as well as more traditional micro factors such as the financial statements of individual companies, news about patents, and everything else that goes into pricing of stocks.

  5. “Just because I may believe the market (sorry, let’s say US Equities as reflected in the S&P 500) is lower than it should be, is this because the market is not efficient or just because other investors don’t share my beliefs and expectations.”

    Excellent summary of the conundrum.

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