Some Things to Remember About Market Plunges

The funniest thing about markets is that all past crashes are viewed as an opportunity, but all current and future crashes are viewed as a risk.

For months, investors have been saying a pullback is inevitable, healthy, and should be welcomed. Now, it's here, with the S&P 500 down about 10% from last month's highs.

Enter the maniacs.

"Carnage."

"Slaughter."

"Chaos."

Those are words I read in finance blogs this morning.

By my count, this is the 90th 10% correction the market has experienced since 1928. That's about once every 11 months, on average. It's been three years since the last 10% correction, but you would think something so normal wouldn't be so shocking.

But losing money hurts more than it should, and more than you think it will. In his book Where Are the Customers' Yachts?, Fred Schwed wrote:

There are certain things that cannot be adequately explained to a virgin either by words or pictures. Not can any description I might offer here ever approximate what it feels like to lose a chunk of money that you used to own.

That's fair. One lesson I learned after 2008 is that it's much easier to say you'll be greedy when others are fearful than it is to actually do it.

Regardless, this is a critical time to pay attention as an investor. One of my favorite quotes is Napoleon's definition of a military genius: "The man who can do the average thing when all those around him are going crazy." It's the same in investing. You don't have to be a genius to do well in investing. You just have to not go crazy when everyone else is, like they are now. 

Here are a few things to keep in mind to help you along.

Unless you're impatient, innumerate, or an idiot, lower prices are your friend
You're supposed to like market plunges because you can buy good companies at lower prices. Before long, those prices rise and you'll be rewarded.

But you've heard that a thousand times.

There's a more compelling reason to like market plunges even if stocks never recover.

The psuedoanonymous blogger Jesse Livermore asked a smart question this year: Would you rather stocks soared 200%, or fell 66% and stayed there forever? Literally, never recovering.

If you're a long-term investor, the second option is actually more lucrative.

That's because so much of the market's long-term returns come from reinvesting dividends. When share prices fall, dividend yields rise, and the compounding effect of reinvesting dividends becomes more powerful. After 30 years, the plunge-and-no-recovery scenario beats out boom-and-normal-growth market by a quarter of a percentage point per year.

On that note, the S&P 500's dividend yield rose from 1.71% in September to 1.82% this week. Whohoo!

Plunges are why stocks return more than other assets
Imagine if stocks weren't volatile. Imagine they went up 8% a year, every year, with no volatility. Nice and stable.

What would happen in this world?

Nobody would own bonds or cash, which return about zero percent. Why would you if you could earn a steady, stable 8% return in stocks?

In this world, stock prices would surge until they offered a return closer to bonds and cash. If stocks really had no volatility, prices would rise until they yielded the same amount as FDIC-insured savings accounts.

But then -- priced for perfection with no room for error -- the first whiff of real-world realities like disappointing earnings, rising interest rates, recessions, terrorism, ebola, and political theater sends them plunging.

So, if stocks never crashed, prices would rise so high that a new crash was pretty much guaranteed. That's why the whole history of the stock market is boom to bust, rinse, repeat. Volatility is the price you have to be willing to pay to earn higher returns than other assets.

They're not indicative of the crowd
It's easy to watch the market fall 500 points and think, "Wow, everyone is panicking. Everyone is selling. They know something I don't."

That's not true at all.

Market prices reflect the last trade made. It shows the views of marginal buyers and marginal sellers -- whoever was willing to buy at highest price and sell at the lowest price. The most recent price can represent one share traded, or 100,000 shares traded. Whatever it is, it doesn't reflect the views of the vast majority of shareholders, who just sit there doing nothing.

Consider: The S&P fell almost 20% in the summer of 2011. That's a big fall. But at Vanguard -- one of the largest money managers, with more than $3 trillion -- 98% of investors didn't make a single change to their portfolios. "Ninety-eight percent took the long-term view," wrote Vanguard's Steve Utkus. "Those trading are a very small subset of investors."

A lot of what moves day-to-day prices are computers playing pat-a-cake with themselves. You shouldn't read into it for meaning.

They don't tell you anything about the economy
It's easy to look at plunging markets and think it's foretelling something bad in the economy, like a recession.

But that's not always the case.

As my friend Ben Carlson showed yesterday, there have been 13 corrections of 10% or more since World War II that were not followed by a recession. Stocks fell 35% in 1987 with no subsequent recession.

There is a huge disconnect between stocks and the economy. The correlation between GDP growth and subsequent five-year market returns is -0.06 -- as in no correlation whatsoever, basically.

Vanguard once showed that rainfall -- yes, rainfall -- is a better predictor of future market returns than trend GDP growth, earnings growth, interest rates, or analyst forecasts. They all tell you effectively nothing about what stocks might do next.

So, breathe. Go to the beach. Hang out with your friends. Stop checking your portfolio. Life will go on.

For more on this topic:

• What I plan to do when the market crashes
• 99% of long-term investing is doing nothing
• How I think about cash

Check back every Tuesday and Friday for Morgan Housel's columns. 

More from The Motley Fool: Warren Buffett Tells You How to Turn $40 into $10 Million