Over the long term, stocks outperform other liquid investments such as bonds and treasury bills. That performance does come with a price of volatility and periodic market declines. A decline of 10% to 20% from a peak is called a correction. Corrections are very common in the market and occur, on average, every 18 months or so. A bear market is one that is in a decline of 20% or more. An average bear market results in a loss of about 30% market value from the peak and lasts 9 to 18 months (sometimes longer).
During the last 100 years, we witnessed 18 bear markets, which included nine protracted bear markets with declines of 30% or more and the greatest of all bear markets, the 1929 Crash, when the stocks dropped almost 90% over 3 years. From the high of 1973, the market dropped 45%. In the crash of 1987, the market dropped 23% - in one day! This volatility plays an important part of a traditional definition of what risk is - namely, a possibility of losing a substantial part of your investment in a relatively short period of time.
The causes for market declines vary. Often, stock market drops are associated with economic difficulties. The memories of the Crash of 1929, which was followed by the Great Depression, still linger. However, behaviors of the markets and the economy can also be decoupled from each other. For example, the 1987 crash did not have any effect on expanding the economy and was simply a correction, as some contend, of overextended equity valuations. Another common reason for market declines is some kind of uncertainty - for example, before an armed conflict. Markets would drop on worries about an impending clash, and would rally once the fighting began. That was the case in 1990, before and during the beginning of the first Iraqi war. At present (September, 2008), we are experiencing the deepest financial crisis since the Great Depression, caused by a number of factors, including a severe correction in the housing market.
Whatever the reason, declines in stocks happen. They are, in fact, recurring and expected events. It may be difficult for you not to be emotionally worried about market swoons - after all, it is not fun watching the value of your savings dwindle in front of your eyes. In rational terms, however, worrying about that is just about as productive as worrying about rainy weather. You don't assume that several days of rain signify the beginning of the next Great Flood. But if you believe financial media during market setbacks, not only will you be convinced that the Great Flood is upon us, but also that the Ark has already sailed and all hope is lost!
I find it very helpful to think of this analogy when the next regularly (or irregularly, as the case may be) scheduled market decline arrives. Granted, it will take time (sometimes several years) for the market to fully recover, but I have full confidence - and historical data to back me up - that it will.
At the time of this writing, we are in the midst of the 19th bear market of the past century. It is also the 10th severe bear market with a drop from the top of over 30%. And without a doubt there will be a 20th bear market and the 11th 30% decline. These pullbacks are all but certain; they are a natural part of the market life cycle, just as winters and summers are natural parts of the life cycle of our planet. A savvy investor should not fear or get upset with such corrections, but be prepared to take advantage of the low prices and a coming upswing in the market.