Before bottoming out, understand the two types of market pullbacks

In the current AI-driven plunge in software stocks, investors must distinguish: Is this a temporary market panic, or is the moat truly collapsing?

Author: Todd Wenning

Translation: Deep潮 TechFlow

Deep潮 Guide: Academic financial theory divides risk into systemic risk and idiosyncratic risk. Similarly, stock declines are categorized into two types: market-driven systemic declines (like the 2008 financial crisis) and company-specific idiosyncratic declines (such as the current software stock crash caused by AI concerns).

Todd Wenning cites FactSet as an example: during systemic declines, you can leverage behavioral advantages—patience to wait for the market to recover; but during idiosyncratic declines, you need to analyze—your vision of the company ten years from now is more accurate than the market’s.

In the current AI shock hitting software stocks, investors must distinguish: Is this a temporary market panic, or is the moat truly collapsing?

Don’t use blunt-force behavioral solutions to address issues that require nuanced analysis.

Full Text:

Academic financial theory posits that risk comes in two types: systemic and idiosyncratic.

• Systemic risk is unavoidable market risk. It cannot be eliminated through diversification, and it’s the only type of risk from which you can earn returns.
• Conversely, idiosyncratic risk is company-specific risk. Because you can cheaply buy a diversified portfolio of unrelated businesses, you will not earn returns for bearing this type of risk.

We can discuss modern portfolio theory another day, but the systemic-idiosyncratic framework is helpful for understanding different types of declines (percentage drops from peak to trough) and how we as investors should evaluate opportunities.

From the moment we pick up our first value investing book, we’re taught to take advantage of Mr. Market’s despair during stock sell-offs. If we remain calm when he loses his mind, we prove ourselves resilient value investors.

But not all declines are the same. Some are market-driven (systemic), while others are company-specific (idiosyncratic). Before you act, you need to know which type you’re facing.

Generated by Gemini

Recent sell-offs in software stocks caused by AI concerns illustrate this point. Let’s look at the 20-year drawdown history between FactSet (FDS, blue) and the S&P 500 (measured via SPY ETF, orange).

Source: Koyfin, as of February 12, 2026

FactSet’s declines during the financial crisis were primarily systemic. In 2008/09, the entire market was worried about the resilience of the financial system, and FactSet couldn’t escape these concerns, especially since it sells products to financial professionals.

At that time, the stock decline had little to do with FactSet’s economic moat; it was more about whether the moat would matter if the financial system collapsed.

In 2025/26, FactSet’s decline was the opposite. Here, concerns were almost entirely focused on FactSet’s moat and growth potential, along with widespread worries that AI’s rapid capabilities would disrupt software industry pricing power.

In systemic declines, you can more reasonably employ time arbitrage bets. History shows markets tend to rebound, and companies with strong moats may even become stronger than before. So if you’re willing and able to remain patient when others panic, you can leverage behavioral advantages.

Photo by Walker Fenton on Unsplash

However, in an idiosyncratic decline, the market signals that the business itself is in trouble. Specifically, it suggests that the future value of the business is becoming increasingly uncertain.

Therefore, if you want to capitalize on an idiosyncratic decline, you need more than behavioral advantages—you need analytical advantages.

To succeed, you must have a vision of what the company will look like ten years from now that’s more accurate than what the current market price implies.

Even if you know a company well, this is not easy. Stocks rarely fall 50% relative to the market without reason. Many formerly stable holders—even some investors you respect for their deep research—may have to capitulate for such a decline to occur.

If you’re going to buy during an idiosyncratic decline, you need an answer to why these well-informed, thoughtful investors are wrong to sell, and why your vision is correct.

There’s only a thin line between conviction and arrogance.

Whether you’re holding stocks in decline or looking to start new positions, it’s crucial to understand what kind of bet you’re making.

Idiosyncratic declines may tempt value investors to seek opportunities. Before risking, ensure you’re not using blunt-force behavioral solutions to address issues that require nuanced analysis.

Stay patient, stay focused.

Todd