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  • Writer's pictureNicholas Pihl

What causes markets to crash (and recover)?

Updated: Feb 13, 2023

The concept of a "stock market" is relatively abstract. We see headlines like, "Dow Jones dropped by 500 points amid recession worries." Whatever the market's movement, pundits always try to offer an explanation, a story to make sense of it. But that's not really how markets work.

The stock market isn't a single entity that responds directly to news headlines. Rather, it is the summation of millions (billions?) of individuals making individual decisions based on what makes sense to them. Some of these decisions are large, such as when the individuals are picking an allocation for a multi-billion dollar pension fund. Others are relatively trivial, such as your buddy deciding to buy a single share of GameStop for $100.

Markets move when the forces of supply and demand are out of balance. And they're almost always out of balance, because the participants on each side of each transaction are always changing, and each of those participants have their own, unique preferences. For example, if someone offered you $1,000,000 to buy your home, you may or may not take that offer. But if you turn that offer down, your neighbor might jump in and say, "hey, I'll sell my home for $1,050,000!" Maybe your neighbor was planning on moving anyway, and just needed the $50,000 to cover a few months of rent while they look for a new place. Who knows?

Stocks are pretty similar. One retiree might be liquidating part of their portfolio to pay for groceries, while another retiree might be selling the exact same stock to pay for a kitchen remodel. The first seller might be forced to take any price they can get, but the second one might be more stubborn about getting a good price. Maybe they'd sell at $40/share, but not at $30/share. Both these people are behaving reasonably for their situation.

This is my main point: all investors are people. They have vacation homes to buy and dreams to secure, especially as they approach retirement. When the market goes up, they get that much closer to their goals. When the market falls, they see those goals recede in the distance. All of these people are making decisions day by day about whether to buy, or to sell. The "market price" is the result of these decisions. It will go to whatever level it needs to go to make a transaction happen, it doesn't care who the buyer or seller are.

Sometimes, the "market price" itself influences the decision making of normal folks. People get used to the market going up, because sometimes it goes up for several years in a row with only minor hick-ups. They expect more of the same, and hold on longer than they otherwise would. Whereas they might rationally sell at, say, $100/share to pay for their kitchen remodel, they might hold on to their stock well beyond that point. It feels like free money when stocks keep going up. Ironically, this absence of sellers allows the market to keep going up beyond what is sustainable, and eventually, a new imbalance forms.

At those high prices, few buyers remain who are willing to pay up for that stock. Meanwhile, a larger number of sellers are enticed to sell at prices that are attractive for them. This imbalance pushes down the stock price until new buyers can be found. Sometimes, very few buyers are available, and the stock price drops quickly.

This is where things get interesting, because once again, the market itself impacts the attitude of its participants. As prices fall, you ironically get even more sellers, not because people are stupid, but because they recognize what is important to them and want to cash out and keep their basic needs intact.

Each market crash is unique, because it's a different set of buyers and sellers each time. In a severe recession like 2008/2009, with high unemployment, many people selling stock were forced sellers. They were unemployed, out of cash, and needed money to pay the bills. Meanwhile, buyers were few and far between for the same reason. Many of those who had the luxury of a good job and a fat emergency fund were worried they might lose their jobs. Rather than put their savings at risk in the market, they tried to be as safe as possible.

When markets recover, it's that same supply/demand dynamic playing out in reverse. Eventually, there are relatively few people left who want (or need) to sell. Meanwhile, many investors remain long-time buyers. These buyers come from a variety of places, whether it's a retiree rebalancing some of their bonds into stocks, or a healthcare worker contributing to their 401k. Without the overhang of desperate sellers, stock prices start to recover again.

I think if there's one thing to take away from this article, it's this: don't be a forced seller. It's relatively simple to do, but it takes discipline and forethought.

To do this, you want to make sure you have a healthy emergency fund of safe, liquid savings that can tide you through several months of unemployment and/or poor market conditions. In addition, you want to make sure that you have the next several years of living expenses provided for. Whereas a young person can expect that they'll find work within a few months, for a 70-year-old retiree, that's not an option.

For retirees in particular, it's important to have a hefty reserve of safe assets in your portfolio. Not only does the reserve need to be large enough to safely withstand several years of poor market returns, it needs to be refilled systematically during good years. Market declines, when met with a big bucket of safe money, offer the opportunity to rebalance advantageously into stocks when they offer the highest returns with the least risk.

At Pihl Financial Planning, I put the safety of your financial future first. Each person receives a customized cash flow and investment plan, tailored to their unique situation. Part of this plan includes a "bucket" of safe reserves to cover the essentials, and to minimize the chances of selling at a bad time.

To learn more about how I manage risk for retirees, even the risks that come from outside their portfolios, schedule an appointment by clicking the button below.

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