While every market decline feels unique, the historical data suggests that the best course of action is almost always to ignore the story and stick to the plan.
The Psychology of the Narrative
Stock prices are essentially a reflection of collective expectations regarding future profits and risks. When these expectations shift, prices change—sometimes violently. While most investors intellectually understand that volatility is a prerequisite for returns, every market drop feels different because every drop is accompanied by a specific, terrifying narrative. As Nobel laureate Robert Shiller explains, narratives are human constructs that mix fact with emotion and extraneous detail to form a lasting impression on the mind. These stories are powerful enough to trigger the framing effect, changing how we perceive objective facts.
When a narrative takes hold, it often leads to representativeness bias, where we ignore historical base rates and instead draw parallels between our current situation and familiar, frightening stories. A narrative doesn't change the underlying facts of the economy, but it fundamentally alters how people respond to those facts. In moments of crisis, the story becomes the lens through which we view our portfolios, often blinding us to the reality that market declines are not a sign of a broken system, but a sign of a functioning one pricing in new risks.
Lessons from the 1918 Pandemic
The power of narrative is best viewed through the lens of history. During the U.S. recession of 1920, the prevailing narrative was one of total systemic collapse. World War I had recently ended, race riots were occurring, and the 1918 influenza pandemic was still a fresh memory. Compounding this was a spike in oil prices and a widespread belief that the nation’s oil supply would be depleted within two decades. At the time, the narrative suggested an irreversible decline in human prosperity.
The economic impact of the 1918 flu was devastating, resulting in a massive reduction in the labor supply and a collapse in retail and entertainment revenue. By December 1920, the S&P 500's cyclically adjusted price-earnings ratio hit its lowest level in history. However, despite the grim narrative, asset prices eventually came screaming back. While the 1929 crash followed a decade later, the pattern remained consistent: markets eventually rebounded. The fear felt by investors in 1920 was real, but the narrative of permanent decline was ultimately proven wrong by the resilience of global commerce.
The Empirical Reality of Rebounds
Skeptics often argue that looking at U.S. history is a form of survivorship bias. However, broader data supports the recovery thesis. Researchers William Goetzmann and Dasol Kim studied 101 global stock markets from 1692 to 2015, identifying over 1,000 instances where a market declined by more than 50% in a single year. Their findings were striking: the probability of a large positive return is significantly higher following a crash than at other times. Each of those 1,032 crashes was likely accompanied by a narrative urging investors to flee, yet the data shows that reducing equity allocation after a crash is often the worst possible move.
The cost of attempting to time these cycles is high. Looking at the S&P 500 from 1926 through early 2020, the compound average annual return was roughly 10%. If an investor missed just the top 10 monthly returns—less than 1% of the total months—that return drops to 7.7%. Crucially, those top-performing months frequently occur during or immediately after major drawdowns. If you exit the market to avoid the pain of the drop, you must also decide when to get back in. Missing the rebound is often more damaging to long-term wealth than enduring the decline.
The Logic of Ownership
To truly lose all your money in a globally diversified portfolio, we would have to reach a point where no one expects any business, anywhere, to earn a profit ever again. This is an extreme and unlikely scenario. When you buy stocks, you are buying a claim on future earnings. When prices drop, it means those earnings are expected to be lower, the businesses are perceived as riskier, or both. This uncertainty is exactly why expected returns go up. Investors are compensated for taking on the risk that others are too afraid to touch.
This is the essence of the equity risk premium. You do not earn returns by being comfortable; you earn them by providing capital when the narrative is at its most frightening. The 21st century has already seen the dot-com crash, 9/11, the global financial crisis, and various pandemics. Despite these events, the MSCI All Country World Index delivered a solid compound return over the first two decades of the century. Investors have a long track record of being compensated for staying the course through periods that felt, at the time, like the end of the world.
Sticking to the Plan
The most important time to follow a financial plan is when it is most difficult to do so. In the heat of a market decline, the decision not to sell may feel regrettable as prices continue to fall. However, everything is obvious in hindsight. The best course of action is to rely on the decisions you made during calmer times. If the volatility of a market drop feels unbearable, it may be a sign that your initial asset allocation was too aggressive for your actual risk tolerance, not that the market is broken.
Uncertainty drives down prices, but it also drives up expected returns. This is not a time to abandon your strategy; it is the time to realize the very premium you invested for. Use your emergency fund for its intended purpose and trust the risk-appropriate portfolio you built. The narrative will always tell you that this time is different, and while the circumstances might be unique, the fundamental logic of investing remains the same: discipline is the only path to long-term success.