Everything You Need to Know About Stock Market Crashes

Since everyone is talking about stock market crashes this week, let’s add some context here…

Since the invention of the Dow Jones Industrial Average at the turn of the last century, there have been eleven instances in which stocks declined by more than 35% from peak to trough, or what you would term a market crash. We’ll talk about how the Dow Jones Industrial Average behaved during these crashes as it is our oldest index; there was no such thing as the S&P 500 until 1957 and the Nasdaq didn’t come along until later.

The most benign of these eleven crashes took place between January of 2000 and October of 2002. It lasted for 999 days and lopped off 37.8% of the Dow’s price, ending that fall at around 7286. The damage in the tech-heavy Nasdaq was obviously much worse but, unless you had abandoned all of your blue chips to chase dot com stocks exclusively, it wasn’t the end of the world. It should be noted that the tech crash was augmented by the uncovering of massive frauds at both Enron and WorldCom and punctuated with the September 11th attacks.

The worst of these eleven crashes took place from April of 1930 and ended July of 1932, investors had lost 86% of their money in just 813 days. This was the big one, far grislier than the 48% killer of the fall of 1929, although that ’29 crash took place in an astonishing two months. Within a few years, stocks would crash twice more. The Dow once again dropped 47% from March 1937 through March 1938 and then another 40% between September 1939 through 1942. This was followed by the Second World War and it took until the late 1940′s before stock prices had fully recovered.

The very first crash in Dow Jones history happened within a year or so of the advent of the index. In June of 1901, the Dow began to fall and it didn’t stop until November of 1903, handing investors (there weren’t many of them in those days) a brutal loss of 46% inside of 875 days. To give you some perspective of what life in America was like during this first crash of the modern era, consider the following facts:

* Life expectancy in the U.S. was 47
* Only 14% of homes had a bathtub
* Maximum speed limit in most cities was 10mph
* Average wage was 22 cents and hour – avg salary/year was about $300
* More than 95% of all births took place at home
* Only 6% of the population had graduated from High School
* The #1 cause of death was Pneumonia and Influenza
* The American flag had 45 stars

We’ve certainly come a long way since then, both in terms of society and the maturation of the modern markets. This is not to say that we don’t remain every bit as susceptible to panics and crashes as we always have. Fear and greed are the two variables that never change throughout human history and certainly since the beginning of the stock market.

Some of these eleven historic crashes had proximate causes – concrete developments we could point to that began the event. Most of them began mysteriously, with no warning or historically important reason. The cause of the 1929 crash is still shrouded in fog, all we know is that markets had been running up in a speculative fever for a decade and then one day – out of the blue –  people didn’t feel like playing anymore.

If you are reading this, it is likely that you will witness another Dow Jones crash of greater than 35% at some time during your life. It could begin tomorrow or you may not see one for decades. There is no schedule and it is unlikely that anyone will be able to pinpoint the spark in advance.

But it is important to remember the following before despairing over the pain that will someday come:

1. Crashes create opportunity and kings will be made during the next one.

2. Crashes clear the system of antiquated industries and business models, paving the way for new fortunes to be made and entirely new ways of doing business and improving our lives. Real estate gets cheap enough for young, innovative companies to take root and begin to change the world all over again. The latest 53% Dow crash, from October 2007 through March 2009, has arguably done exactly that.

3. There’s never been a stock market crash that the Dow hasn’t recovered from, and there’s never been a crash that’s gone on for longer than 1000 days before bottoming.

4. Crashes are extremely rare, while we’ve averaged one crash per decade since the Dow Jones came into existence, four of them have taken place in the span of one ten year period.

5. The Dow bottomed out at 30.88 after its very first crash. It revisited that level precisely upon bottoming out during the crash of 1906-1907 and then came close once again during the horrors of the early 1930′s. The amount of subsequent wealth creation that came as a result of weathering these periods cannot be overstated. Since the dawn of the index through last year, the Dow has returned an annual average of 9.4%  – half from capital appreciation and half from dividends. Those who’ve attempted to dance in and out, constantly expecting a crash, have likely captured very little of that, if any at all.

Most of your favorite crash-fetishists have track records that you wouldn’t wish on your worst enemy. It is one thing to be aware of the potential for terrible things to happen, it is quite another to give up on life and opportunity altogether.