Why aren't market crashes necessarily risky?

Disclaimer: Please note that all content and information in this blog are for educational and informational purposes only and should not be taken as professional investment advice.

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Oftentimes people associate market crashes with huge panic sell-offs, volatile market swings, capitulation and free-falling asset prices. In other words, risk. While not wrong, it ignores the fact that it's during such times that investors are more cautious and risk-averse. 

Unlike bull runs, market rallies or bubbles, during crashes, investors become extremely cautious and careful with how and where they deploy their money. In fact, many often hold back from buying and resort to less risky assets like bonds or even cash. When the majority does that, the market bottoms and rebounds.

But why are markets less risky during such times? Isn't there volatility and uncertainty?

Well, it's not wrong that it's risky because it's volatile. But a key trend many fail to observe is that market crashes happen when majority of investors become risk-averse. And it's this widespread risk-aversion (or fear) in the market that makes market crashes inherently less risky compared to market rallies or bubbles.

During market rallies, many investors are confident and optimistic in the market, and as such wouldn't think twice about investing, driving asset prices higher and higher. 

In other words, investors are less risk-averse during market rallies. The opposite happens during crashes where there's blood on the street and investors think twice before investing in the market.

Oftentimes many end up not investing at all, or worse still, selling at the very bottom of the crash. Because so many investors have opted to stay on the sidelines and not invest because of fear, asset prices free-fall, posing great buying opportunities for seasoned investors unperturbed by neither the volatility nor bad news of the market. 

Such investors know that the prime time to be snapping up assets is when everyone else is risk-averse (fearful) and holding half their investments. It's during such times that the greatest wealth is created. It's through fear and panic that opportunities for wealth creation arise.

So, back to the point: Why aren't market crashes necessarily risky?

When everyone in the market is fearful and risk-averse, nobody would be buying up assets perceived as "risky" like equities. Instead, they would take refuge in safe haven assets like bonds or cash. When nobody is buying up the "riskier" assets like equities, what happens to the risk of such assets? It drops! Why?

There is a negative correlation between asset price and risk.

Generally speaking, the higher the asset price, the higher the risk, because the higher the probability the asset falls below your buy price. 

In other words, a higher probability of suffering losses, while the converse is true: you have a lower probability of experiencing gains by buying at a higher price. 

The opposite happens during market crashes: you buy at lower price, lowering the probability the asset price falls below your buy price, and raising the probability the asset price rises above your buy price.

In other words, buying low lowers the risk of losses and increases the probability of gains, while buying high does the opposite: increases the risk of losses and reduces the probability of gains. So by buying low during crashes, you are essentially taking on less risk compared to buying high during rallies.

And that's the paradox of the market—the fact everyone thinks the market is risky, makes it less risky, and the fact everyone thinks the market is not risky, makes it more risky.

By following the herd mentality, you would succumb to the mean. But by following the contrarian mentality, you would deviate from the mean. Whether you deviate positively or negatively depends on whether you act rationally or irrationally. There are times when following the market trend is good (e.g. holding assets during a wave up) while there are times when following the market trend is bad (e.g. selling off during crashes).

As long as you are able to consistently act contrary to the market during crashes, you would outperform the market. 

By simply buying when everyone is selling during crashes, you are almost certainly guaranteed to outperform everyone else when the market rebounds. Following this contrarian mindset during crashes enables you to emerge on the winning side of the probability distribution, producing abnormally higher returns compared to the market average.

In short, be a contrarian during capitulation. And be cautious when everyone is confident.

1. Acting contrary to fear and being cautious during optimistic times will enable you to avoid buying high and selling low.

2. Be bullish when everyone is bearish, and be bearish when everyone is bullish.

3. Be optimistic when everyone is pessimistic, and be pessimistic when everyone is optimistic.

These are some useful ways to ensure your emotional temperance and sanity remains in check during times of market capitulation or exuberance. 

When the market is feeling exceptionally low, take it as a buying opportunity. When the market is feeling exceptionally high, take it as a selling opportunity.

Most importantly, stay invested and avoid timing the market with your investments—leave timing to your trades. 

Trade by timing the market, while invest by time in the market.

Following these strategies when investing will enable you to assess when the market is risky and when it's not, allowing you to exploit the misprices during such times to profit greatly in the long run.

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Disclaimer:

The content and information provided on this blog is solely for educational and informational purposes, and should not be construed as financial advice. The accuracy or completeness of the content and information provided in the blog cannot be guaranteed. Before making any investment decisions, it is important for readers to research and carry out independent verification of the information provided, or consult with a qualified financial professional. No warranty and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of actions taken based on the ideas or information found in this blog.

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