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.