|
A 5% market dip is one of the most normal events in investing. So why does it reliably send sentiment off a cliff?
Every market drawdown, you'll see the same red banner headline: “Stocks sell off as Wall Street worries about X”.
The S&P 500 drops 4–5% from a recent high, and the tone notably shifts. Pundits start talking about caution, allocations get “reassessed,” and risk becomes the focus. Scroll through investment forums and it sounds even worse: “Bear market incoming”. “Market is officially broken”. “The smart money got out weeks ago”. Somebody always has a thesis. What makes this so remarkable is how routine the trigger is. Since 1980, the S&P 500 has declined 5% or more in 93% of all calendar years.¹ These dips occur 4-5 times per year on average.² The event that sends investors into crisis mode is, statistically speaking, closer to a scheduled occurrence than a warning signal. Yet, sentiment data shows the same thing over and over: bearishness spikes quickly and sharply the moment one of these pullbacks arrives. Why do these dips always feel so worrying? Why is our emotional response so consistently out of proportion to what the data suggests?
Volatility is a Part of Investing
Total # of 5%, 10%, 20%, 30%, 40%, 50% drawdowns in the S&P 500
Since 1950
Total # of drawdowns (since 1950)
Source:Factset
Flaws in the Brain The most direct answer to these questions is our brains. Here's what is going on: Loss Aversion In the late 1970s, Daniel Kahneman and Amos Tversky documented the finding that losses register psychologically at roughly twice the intensity of equivalent gains.³ This means a 5% drop registers more like a 10% drop than a 5% drop. It feels bigger, more threatening, and more urgent than it actually is. While this natural instinct proved useful for human survival, it just doesn't have a productive outlet in a retirement account. Recency Bias This is the brain's tendency to treat the most recent data as the most predictive. After a few consecutive down days, investors start to see a trend emerge — “evidence” that something has fundamentally shifted. And it’s a snowball effect. The brain essentially pattern-matches on the only data that feels relevant right now, which just so happens to be the most negative data the market has seen in several months. Herding Now layer in how information spreads in this day and age. Open Reddit, X, or the comments on a financial news article during a pullback. What you're seeing is not a representative sample of investor opinion. In a declining market, the most activated voices are almost always the most fearful. Fear, in a crowd, gains steam and notoriety faster than any other signal available. The Silicon Valley Bank collapse in March 2023 is the most dramatic illustration of this dynamic on record. Depositors pulled $42 billion in a single day (roughly $1 million per second) after concerns spread rapidly across Twitter.⁴ For context, the previous largest bank run in modern American history, at Washington Mutual in 2008, took ten full days to accumulate $16.7 billion in withdrawals. Social media may not have invented panic, but it certainly compressed the timeline from days into hours.
Sentiment Moves Faster Than the Market Does
The American Association of Individual Investors has surveyed retail investors every single week since 1987. The question is simple: do you expect markets to be higher or lower six months from now? The historical average for bearish responses is around 31%.⁵ What the data consistently reveals is that bearish readings can surge 15 to 20 percentage points in a single week, well before there's any evidence that a routine pullback is becoming a more serious price correction.⁶ The market moves down a few percent and sentiment drops like a rock.
When Negativity Leads to Bad Decisions
When our outlook gets too negative and we decide to fly to safety (i.e. move to cash), we are actively deciding to miss out on experiencing the market’s best days. According to JP Morgan's research, a $10,000 investment held fully from July 2004 through July 2024 returned 10.5% annually.⁷ Miss the 10 best days? → 6.2% annually Miss the 20 best days? → 3.6% annually Miss the 30 best days? → 1.4% annually
The Cost of Missing the Market's Best Days
Growth of $10,000 invested in the S&P 500 — July 2004 to July 2024 — 7 of the 10 best days occurred within 15 days of the 10 worst days
Source: J.P. Morgan Asset Management, Morningstar Direct. S&P 500 Total Return Index. For illustrative purposes only.
This is what makes reactive selling so destructive.
Even though selling risk assets feels protective in the moment, it’s typically a mistake in the long run. The math on missing even a handful of those great days in the market is significant.
The Counterargument Worth Taking Seriously
To be clear: not every pullback resolves quickly, and not every bearish instinct is wrong. Pullbacks can become corrections, and corrections can turn into drawn-out bear markets. I’m not going to dismiss fear for the sake of ignoring real risk. Here’s a more precise framing: a 5% decline carries very little statistical information about what follows it. The average recovery from a 5-10% correction is approximately three months. ⁸ Most years that include a double-digit intra-year drop still finish positive. The mistake is treating a single chapter like the entire book. Just because we drop 5% doesn’t mean we’re doomed to experience a 20% drawdown.
Conclusion
Loss aversion is real. Recency bias is real. Herding is Real. The fear and anxiety that a small decline turns into something worse is real. But is it statistically justified after a few percentage point drop? Not so much. Since 1980, the average intra-year decline has been around 14%, while the average annual return has been 13%.⁹ Dips and recoveries are two parts of the same story. The investors who sit through the full story tend to come out ahead. The ones who act on their fear, especially when that fear is being amplified in real time by others, tend not to. If you can filter out the sea of coordinated emotional experiences dressed up as analysis, you’re more likely to succeed in long-term investing. More Reading: Your Body Has a Retirement Plan. It Probably Doesn’t Match Your Financial One. The Trip Is Non-Negotiable, But the Experience Depends on Your Financial Reality Many People Don't Need to Hire a Financial Planner. Here's How to Know If You're the Exception. References: ¹ Fidelity Investments — A Game Plan for Market Corrections ² Covenant Wealth Advisors — Understanding Stock Market Corrections and Crashes ³ Kahneman, D. and Tversky, A. Prospect Theory: An Analysis of Decision Under Risk, Econometrica, 1979 ⁴ American Action Forum — The Collapse of Silicon Valley Bank, March 2023 ⁵ American Association of Individual Investors (AAII) Sentiment Survey, historical averages ⁶ Advisorpedia — Surging Bearish Sentiment: A Warning Sign or Overreaction?, 2025 ⁷ J.P. Morgan Asset Management, Morningstar Direct. S&P 500 Total Return Index, July 2004–July 2024 ⁸ Invesco — Stock Market Corrections and What Investors Should Know ⁹ Fidelity Investments — A Game Plan for Market Corrections
0 Comments
Your comment will be posted after it is approved.
Leave a Reply. |
RSS Feed