How Common are Market Declines?
Periods of stock market decline are as natural as full moons, but not as predictable. In the 1990's, stock advances have been abnormally large and unusually persistent, declines have been rarer than their historical frequency and shorter-lived.
Why do markets decline? Some observers point to excessive security valuation, economic change, political change, or random unsettling events in the world. My suspicion is that human psychology -- playing off these triggers -- has a very large role. Just as people can get depressed after experiencing some peak of excitement or fulfilling a difficult goal, the markets people create can retrench after an exuberant climb.
How often do declines occur? How deep can they be? The following answers are taken from fifty years of Dow Jones Industrial Average ["DJIA"] data analyzed by Ned Davis Research (Wall Street Journal, 1994)...
Let's review the first data column in words so we fully understand. It says: a "Dip" is a decline greater than or equal to 5% (but less than 10%) from the previous Dow Jones Industrial Average high. Dips have occurred more than twice a year on average. A typical Dip produces a 9% decline before it's over. There's only a 26% chance [about 1 in 4] that a Dip will deepen into a "Moderate Correction".
We also learn that "Moderate Corrections" of 10% to 15% have occurred every 18 months, but that "Severe Corrections" of 15% to 20% only developed once every three years on average.
The last row of the table shows the "snowball effect" in downtrends: the deeper losses become, the more likely they'll continue to the next level of decline.
We shouldn't be sanguine about withstanding the psychological pressure of "Dips" or deeper declines because diversified portfolios will usually show bigger losses than the DJIA. If the bedrock Dow Jones Industrial stock prices drop 5% or 10%, the typical listed stock will fall far more! That leads us to consider...
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