Markets fall. This is not a warning or a prediction. It is a description of how markets have always worked.
Understanding why markets decline does not help you avoid them. No one can reliably predict when falls will happen or how deep they will go. But understanding the mechanics of decline can help you respond more calmly when it happens, and reduce the chance of making decisions you later regret.
This article explains the main reasons markets fall, why news is an unreliable guide to market direction, and why having rules written in advance tends to produce better outcomes than reacting in the moment.
This is general educational information, not personal financial advice.
The Regularity of Decline#
Market declines are not rare. They are a recurring feature of investing.
Looking at historical data for major share markets, corrections of 10% or more occur roughly once per year on average.¹ Declines of 20% or more (often called bear markets) occur roughly every three to five years. Declines of 30% or more, while less frequent, have occurred multiple times in living memory: 2008, 2020, and the early 2000s.
This does not mean declines are predictable in timing. It means they are predictable in occurrence. Anyone who invests for decades will experience multiple significant downturns. The question is not whether, but when, and how you respond.
Why Markets Fall: Three Broad Categories#
Market declines generally stem from one or more of three sources: economic cycles, sentiment shifts, and valuation resets. These categories overlap, but separating them helps clarify the mechanics.
Economic Cycles#
Economies expand and contract. During expansions, corporate earnings grow, employment rises, and confidence increases. During contractions (recessions), the opposite happens: earnings fall, unemployment rises, and spending slows.
Share markets tend to anticipate these cycles rather than follow them. Markets often fall before a recession is officially recognised, and begin recovering before the economy shows clear improvement. This is because markets are forward-looking: prices reflect expectations about future earnings, not just current conditions.
This creates a frustrating pattern. By the time economic news confirms a downturn, markets have often already priced it in. By the time the news improves, markets have often already recovered. Waiting for clarity usually means missing the turn.
Sentiment Shifts#
Markets are not purely rational. They are influenced by collective psychology: optimism, fear, greed, panic. These emotions can amplify moves in both directions.
During periods of optimism, investors tend to pay higher prices for the same earnings. During periods of fear, they pay less. This is sometimes called the "mood" of the market, and it can shift quickly, sometimes without any obvious change in underlying fundamentals.
Sentiment shifts explain why markets can fall sharply on news that, in hindsight, seems minor, or barely react to news that seems significant. The same information can produce different market responses depending on the prevailing mood.
Valuation Resets#
Valuations refer to the price investors pay relative to earnings, dividends, or other measures of value. When valuations become stretched (prices high relative to fundamentals), markets become vulnerable to resets.
Valuation resets do not require bad news. They require a change in expectations. If investors had been pricing in 15% earnings growth and now expect 8%, prices adjust downward even if 8% growth would normally be considered healthy.
High valuations do not cause immediate declines. Markets can remain expensive for extended periods. But elevated valuations increase fragility: there is less room for disappointment.
News Does Not Equal Signal#
One of the most disorienting aspects of markets is the disconnect between headlines and price movements.
The same headline can produce opposite reactions depending on context. "Interest rates rise" might cause markets to fall (higher borrowing costs) or rise (confidence in economic strength). "Company reports lower earnings" might cause a stock to drop or rally, depending on whether the result was better or worse than expectations.
This is because markets do not react to news. They react to news relative to what was already priced in. If bad news was expected and the actual news is less bad, prices can rise. If good news was expected and the actual news is merely okay, prices can fall.
For investors, this has an important implication: following news closely does not provide an advantage. In fact, it often creates noise that leads to poor decisions. The investor who reads every headline and tries to interpret what it means for their portfolio is more likely to trade excessively and time poorly than the investor who ignores most news entirely.
The Emotional Challenge of Declines#
Knowing why markets fall does not make it feel better when they do.
Declines trigger loss aversion, the well-documented tendency for losses to feel roughly twice as painful as equivalent gains feel good.² A 20% decline hurts more than a 20% gain pleases. This asymmetry is not irrational; it is biological. But it leads to predictable mistakes.
The most common mistake is selling during a decline. The pain of watching losses accumulate becomes unbearable, and selling provides relief. But selling locks in losses and often means missing the recovery. Research consistently shows that the best and worst days in markets tend to cluster together.³ Missing just a handful of the best days can dramatically reduce long-term returns.
The second common mistake is freezing: stopping contributions, avoiding looking at statements, and hoping the problem goes away. This is less damaging than panic selling, but it still interrupts the process of regular investing that compounds over time.
Pre-Written Rules: The Behavioural Solution#
The best time to decide how you will respond to a market decline is before it happens.
When markets are calm, it is easier to think clearly about what matters. You can consider your time horizon, your need for liquidity, and your actual capacity to tolerate volatility. You can write down rules for yourself: what you will do if markets fall 10%, 20%, 30%.
Common approaches include:
- Continue regular contributions regardless of market conditions. This takes advantage of lower prices during declines.
- Avoid checking portfolio values more than once per quarter. Frequent checking increases emotional volatility without providing useful information.
- Rebalance on a schedule rather than in response to news. This removes timing decisions from the process.
- Set a "do not sell" rule for a defined period. Some investors commit to not selling any holdings for at least one year after purchase, regardless of what happens.
These rules are not magic. They are friction. They slow down the reactive part of the brain long enough for the rational part to catch up.
The key is that the rules must be written in advance. During a decline, the emotional brain is in control. It will rationalise selling as sensible. It will find reasons why "this time is different." Rules written in calm conditions provide a counterweight.
What History Suggests#
Every significant market decline has eventually been followed by a recovery. This is true of the Great Depression, the 1987 crash, the dot-com bust, the 2008 financial crisis, and the 2020 pandemic crash.
This does not guarantee future recoveries. Past performance is not a reliable indicator of future results. But it does suggest that selling during declines has historically been the wrong decision for long-term investors.
The catch is that "eventually" can mean years. The recovery from the 2008 crisis took roughly five years to reach prior highs. The dot-com recovery took longer. Investors who needed their money during those periods had fewer good options. This is why time horizon matters, and why money needed in the short term is generally not suited to volatile assets.
Summary#
Markets fall regularly, roughly once per year for 10% corrections and every few years for larger declines. The causes include economic cycles, sentiment shifts, and valuation resets, often in combination. News is an unreliable guide because markets react to expectations, not just events. The same headline can produce opposite reactions depending on context. Declines trigger loss aversion and lead to predictable mistakes: panic selling and freezing. Pre-written rules, created during calm periods, provide friction that helps prevent emotional decisions. History suggests that recoveries follow declines, but the timing is unpredictable. Long-term investors who stay invested tend to fare better than those who try to time their exits.
Sources#
- Schwab Center for Financial Research. (2023). Market corrections and bear markets. Charles Schwab. https://www.schwab.com/learn/story/market-corrections-are-more-common-than-you-think
- Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263-291. https://doi.org/10.2307/1914185
- J.P. Morgan Asset Management. (2024). Guide to the markets. https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/