Economic Black Holes: Understanding Market Downturns

Black holes are one of the universe’s greatest mysteries. What causes them to occur? How do they start? How long do they last for? Nobody really knows. In the world of finance, market downturn are just like black holes – they’re big swirling balls of mystery that strike fear into investors’ hearts. 

Now, I may not be able to answer every single question that you have about market downturns (because there’s a lot that investors don’t always know). But, in this article, I took my best stab at explaining market downturns (AKA economic black holes). Hopefully, it will give you a bit more reassurance on your investment journey.

What is a Market Downturn?

In layman's terms, a market downturn is when a stock market experiences losses for a certain period of time. Just like black holes, market downturns are typically unexpected and tend to catch investors by surprise. Sometimes, they only last for a few weeks. But, in bad cases, market downturns can last for years. Investors use several different terms to classify market downturns, depending on how long they last:

Market downturn: A slight downturn in the market that is fairly short-lived, only lasting for a few days to weeks.

Bear market: A market decline of 20% or more, typically ranging from three months to three years.

Recession: When the United States experiences two or more consecutive quarters of negative economic growth, per Investopedia. Recessions are almost always accompanied by a falling stock market. 

Depression: A depression is a severe and prolonged downturn in economic activity that usually lasts for three or more years and leads to a GDP decline of at least 10% in a given year. These are much more rare than mild downturns or recessions.

Since the stock market is constantly fluctuating, market downturns are fairly common over the short term. For instance, a stock market drop of 1% or 2% during the week is very common and no cause for concern. It’s not considered a “market downturn” until the downward trend stretches on for weeks.

What Causes a Downturn?

Market downturns are typically caused when investors react to negative events. These are typically major macroeconomic events like an increase in interest rates, a major political event, or a war. But, market downturns can also follow periods of sustained growth. Let’s examine both scenarios.

Investors Reacting to Negative Events: In most cases, investors will react to negative news by selling off their investments, which drives the market down. If you never took Econ 101, more people selling in a market drives prices down (while more buying drives prices up). This concept applies readily to the stock market. So, once bad news has been released, many investors will sell their investments. Once stock prices start to drop, other investors panic and rush to sell their investments too – which only drives the stock market down further. This is how mild downturns can turn into recessions or even depressions.

Downturns That Follow Bubbles: Another thing to note is that downturns can (and often do) follow periods of irrational exuberance. If investors are incredibly excited about something – like a new technology – then they may start scrambling to buy more stock in hopes of scoring big on “the next big thing.” When this happens, the reverse scenario plays out. Investors scramble to buy as much stock as possible, which drives prices up. As the market soars, other investors start to panic and feel FOMO (Fear of Missing Out) so they start to buy as well. The market soars to new highs and seems unbeatable. That is, until investors realize that the market is overvalued. They rush to pull their money out and everything comes crashing down. Investors refer to these scenarios as “bubbles.”

With that in mind, let’s take a quick look at famous (and recent) stock market downturns.

Quick History of Market Downturns

The world’s history is riddled with different market downturns. But, for the majority of US investors, there are only a few market downturns that have occurred over the past few decades.

The 2001 Dot Com Bubble: This is a famous “bubble burst” that occurred between 2000 and 2002. During this period, many technology companies crashed in price after getting overbought during the “internet frenzy” of the late 1990s.
The 2008 Financial Crisis: This was a much more serious financial crisis (appropriately called “The Great Recession”) where the market dropped about 50% from 2007 to 2009 thanks to subprime lending in the mortgage market.
The 2020 Covid Crisis: Most recently, the stock market dropped 30% in the span of a few weeks after the Covid-19 crisis entered the US. There was a severe drop, followed by a quick rebound. 

Preparing Your Portfolio

Now it’s time for the most important part of the article: how to prepare your portfolio against market downturns. In other words, how can you successfully avoid a black hole if you think one might be approaching?

To start, there’s really no way to completely avoid market downturns. They’re just part of life for investors. This is because there’s no way to tell for sure when a downturn is coming. Technically, you could sell off all of your investments every time you sensed a crash coming. But, you’d be worse off over the long run because you’ll inevitably guess wrong most of the time.

That said, there are three main strategies that investors use to protect themselves from market downturns. 

Diversify your portfolio: Investing 100% of your cash in assets that are tied to the stock market can put you at more risk during a market downturn. Instead, you should consider diversifying your holdings across different assets. This means holding a range of stocks, bonds, cash, and even real estate or other assets.
Practice safe investing principles: It’s always advisable to continuously add to your investments, particularly by dollar-cost averaging. This can help mitigate the effects of a downturn. Additionally, avoiding investing in single stocks if you have a low tolerance for risk. Instead, consider buying shares of index funds – which can help you diversify your portfolio.
Invest more when the market’s down: This one might sound a little counterintuitive – like I just told you to steer right for a black hole when you see one. But hear me out; most market downturns are fairly short-lived. So, when the market is down, many investors actually encourage you to invest more money. This can help you buy stock at a cheaper price and benefit when the market turns around.

When it comes to market downturns, many investors will do their best to live by the words of legendary investor Warren Buffet, “Be fearful when others are greedy and greed when others are fearful.” In other words, if you feel that many people are being overly aggressive with their investments, then it might be a good time to pull back. But, on the other hand, if you feel that panic is in the air then it might be a time to lean in a bit heavier on your favorite investments.

We hope that you’ve found this article valuable when it comes to learning about economic black holes, also known as market downturns. If you’re interested in learning more then please subscribe below to get alerted of new articles as we write them!