Deep dive into stock market drops – lessons from history

The past few years have been bumpy for investors. We’ve watched markets and the economy tumble and rally as a reaction to the global pandemic. The war in Ukraine has added fuel to the ongoing uncertainty through rising commodity prices and squeezing household incomes too.

More recently, there have been three main trends causing uncertainty – inflation, interest rates and the pound.

The increased cost of living has started to bite. Inflation is still rising and is expected to reach 14% by the end of the year. The Bank of England (BoE) recently increased interest rates by 0.75% to 3% – the seventh interest rate rise this year. The pound also dropped to a record low against the dollar after previous prime minister, Liz Truss, announced her mini-budget back in September.

Certainty in the uncertainty

The only thing that’s almost certain is the UK going into a recession in 2023. The BoE’s latest view is that recession is coming, with potential for it to be the longest recession since the second world war. How bad it is depends on how high interest rates have to go to bring inflation back under control.

When a country is running smoothly, the value of the goods and services it produces – its gross domestic product (GDP) – grows.

But during times of downturn to an economy, this value falls. A recession is when GDP drops for two three-month periods in a row. It’s a sign the economy is weakening – it usually means salaries drop and redundancies rise.

All of these factors can impact markets in different ways. But what does this all mean for investors and how should we react when we see stock markets moving in swings and roundabouts?

We’ve gone back in time and had a closer look at some of the biggest market drops, the causes, effects and how long the market took to recover.

The key point in all of this is that after each drop, the market eventually recovered.

Unfortunately, market drops don’t come with a guide and this article isn’t one either. Past performance isn’t a guide to the future, but there are things we can learn from history to make us better investors today.

This article is not personal advice, so if you're not sure if an investment is right for you, please ask for advice. Unlike cash, all investments fall as well as rise in value, so you could get back less than you invest.

Investing for the long term – we really mean it

Market drops can be worrying. Seeing the value of investments fall isn’t nice and blaring headlines don’t help.

But at times like these, it’s good to go back to basics. Market drops don’t last forever and we’re investing for the long term – that’s not a few months, a year or even five. It’s longer.

UK stock market returns during period of volatility

Past performance isn’t a guide to the future. Source: Thomson Reuters Eikon, 10/11/22.

You can see from the highlighted areas in the chart above that there have been periods of volatility. We've highlighted the start of each event so you can see how the market moved over a short term period of two years. But, all in all and over the long term, the UK stock market has risen when we look at it through a long-term lens.

Previous market drops and comebacks

This chart below looks at some of the biggest falls in value of the UK stock market since 1985 and how long it took to recover. For these examples, we assumed you’d invested at the highest point before the market started to fall.

Value of UK stock market following drops

Past performance isn’t a guide to future returns. Source: Thomson Reuters Eikon, 19/07/2021. Where no figures are shown, data is unavailable.

The pandemic

The coronavirus outbreak and an oil price crash sent markets tumbling in March 2020. We saw some of the biggest daily falls in history.

As the pandemic began to spread in March 2020, we saw stock markets across the globe plumet. The FTSE All Share index fell by 35% between 2 January and 23 March 2020.

This was difficult to stomach at the time. But by December 2021, the FTSE 100, which is made up of the 100 biggest companies on the UK stock market, had returned to pre-pandemic levels. This was largely down to announcements of new vaccines being released.

We’re still feeling the effects of the pandemic, and Covid-19 is still very present in our daily lives. Despite the world seemingly slowly returning back to ‘normal’, this highlights how receptive markets are to headlines and how we learn to adapt to new environments.

Lesson from the pandemic

Don’t let the short term effect your emotions. A long-term view of the market is essential.

Black Monday 1987

19 October 1987 holds a place in the record books for being one of the biggest market drops ever. The US S&P 500 saw its biggest ever one day drop in value of 20.4% and the UK market fell by around 10% on the day – before falling further in the following days.

Leading up to the crash in 1987, the UK market alone had risen 47% in just over ten months. In the UK, it felt like the time to invest.

However, with hindsight many see the 1987 crash as a ‘perfect storm’, where euphoric markets were met by a few different shocks and panic selling ensued.

This is often the case for stock market busts. Yes, there were specific triggers, there always are. In this case, a change in US tax legislation that hurt big acquisitive businesses and a whole host of complex, and often automated trading strategies, played a role.

But this bust followed an excessive boom – if it wasn’t the tax change, something else would probably have spelt the end.

As the chart shows, if you’d invested in the run up to the crash, your returns wouldn’t have looked pretty for a few years. But over the long term, you would’ve more than made your money back.

Lesson from 1987

“Be fearful when others are greedy, and greedy when others are fearful.”

Warren Buffett – one of the greatest investors of our time.

Dotcom bust

While 1987 was a time of market euphoria, the dotcom bubble was made of something stronger – mania.

Tech, e-commerce and telecoms companies were going to change the world and people were willing to pay anything to be part of it.

The US tech focussed NASDAQ soared 86% in 1999 and average valuations reached 170 times earnings in November that year. At one point, Yahoo was worth more than General Motors and Ford put together – people were willing to pay 1,000 times the next year’s earnings.

Revolutionary ideas and promises of future earnings growth were plenty. But actual profits or ways to make them were often lacking. Promise alone doesn’t make a solid foundation for investments and many learned this the hard way.

Ultimately there were some good ideas in the mix – Amazon was one of them. But at the time, the winning company or technology wasn’t clear – everyone was going to win. When thinking about which companies or technologies to invest in, we think it’s best to wait until the winner is clear.

Lesson from the dotcom bust

Invest in profit, not prophets.

Great Financial Crisis

Whether it was savers queuing round the block to get their money from Northern Rock or bankers pouring out of offices with their stuff in boxes – the financial crisis had a very human impact.

Fundamentally, the 2008 financial crisis was a crisis in confidence. Concerns that started in the US mortgage market spread to the entire financial system. Fears mounted and lending dried up. Unfortunately for some, borrowing was essential, and defaults followed.

The collapse of Lehman Brothers, a large Wall Street investment bank, on 15 September 2008 became the iconic moment of the crisis. The initial market reaction wasn’t huge. But as the scale of the problem was recognised, many more banks looked like they could face the same fate. The market dropped further – by March 2009 it was nearly half of its pre-crisis value.

Government responses came, banks were bailed out, interest rates cut – anything to stop the financial system grinding to a halt altogether. They were successful to some extent, but not before a financial crisis became an economic one too. Companies struggled, people lost their jobs and economies slumped.

There’s no denying this was a big one, but there is a happier ending.

It wasn’t a straight climb back up, but businesses, economies and markets did recover. After three years, an investment in the UK market was back in positive territory.

Lesson from great financial crisis

Stay calm, stay diversified, and stay invested if you’re happy to accept the risks.

Brexit referendum

June 2016 took the world by surprise. Polls and bookies were adamant the UK would vote to remain. But on the day, 51.9% voted leave.

Also taken by surprise, the UK stock market fell 4% the next day and was down 7% the following Monday.

While the drop will have reflected some investors’ fears that Britain wouldn’t be better off alone. There was also selling pressure from some bigger investors – making right some big bets they’d made for a ‘remain’ vote.

Either way, the market drop was one of feeling more than facts related to businesses or the UK economy at the time. Despite the headlines, it wasn’t long before a recovery took hold.

Lesson from Brexit

Don’t make decisions based on headlines.

Practical tips for uncertain markets

History has taught us that market drops come in all shapes and sizes, making them tricky to predict.

The current market and economic environment is no different – it’s likely to be bumpy for a while. During times like these, we think it’s best to focus on the things you can control.

Make sure you’re happy with your portfolio and the split between different types of investments and cash. With recent events, looking at the amount you hold in shares (or funds investing in shares) is likely to have been similar to watching a roller-coaster ride.

Try to build a portfolio that’s diversified so you usually have something working in your favour.

You could even use money from your investments that are doing well, to top up ones that aren’t. And you don’t have to do it all at once. Shifting bit by bit could be a good approach as it lets you adjust to changes in the market as they come.

How to review your portfolio

You could also consider adding to investments on a regular basis to help you make the most of more challenging times. It can be a lower-risk strategy and investing regularly could help you benefit from lower prices. Drip feeding into a volatile market could mean the average price you pay for your investments ends up being lower than a single lump sum investment.

Whatever you decide to do, a long-term investment horizon is essential.

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