- A stock market crash is a sudden or severe drop in overall share prices, usually within a day.
- Stock market crashes can be due to economic or natural disasters, speculation, or investor panic.
- Investors can prepare for stock market crashes by diversifying portfolios and shifting to CDs or bonds.
The stock market is constantly moving, with prices of individual equities rising and falling throughout the trading day. Whenever the majority of them — or a representative group of them, called a stock market index — takes an especially large dive, a panicked cry often arises: “The stock market has crashed!”
Stock market crashes are certainly scary. Equities across the board decline in value. Investors lose enormous sums of money — on paper, anyway. But what causes them? And what are the aftereffects?
Here is a closer look at what a stock market crash really is and what you need to know before one impacts your portfolio.
What happens when a stock market crashes?
There are many definitions of what a stock market crash is. Some categorize a crash strictly as a stock market or a stock market index (a representative sampling of stocks) losing more than 10% of its value in a single day. Others provide a more general view, simply stating that a crash is a significant or dramatic loss in the stock market’s value, and the prices of shares overall, usually within a short period of time.
Any way you look at it, a stock market crash happens when confidence and value placed in publicly traded assets goes down, causing investors to sell their positions, and move away from active investing, and toward keeping their money in cash, or the equivalent.
The impact of a crash can vary as well. Sometimes, it’s limited. For example, on Oct. 19, 1987, after five years in a strong bull market, the Dow Jones Industrial Average (DJIA) and S&P 500 both dropped more than 20%, following markets throughout Asia and across Europe. The crash was short and markets quickly recovered. Within a few days, the DJIA regained more than 43% of the points it lost and within nearly two years the market had recovered almost 100%.
At other times, the effects are widespread and longer-lasting. The most notorious example is the Crash of 1929. Stock prices dropped first on Oct. 24th, briefly rallied — and then went into free fall on Oct. 28-29. Ultimately, the market lost 85% of its value. Though not the sole cause, this crash was one of the contributing factors of the Great Depression, the worst economic period in American history, lasting nearly 10 years.
What causes a stock market crash?
Historically, stock market crashes often occur after a long period of economic and market growth. Confidence in the economy, steady stock gains, and low unemployment are all drivers of bull markets, as these sustained rallies are known. As more and more stocks are purchased, prices go up — both of individual equities and of the stock indexes themselves.
But in the world of securities, prices can’t keep rising indefinitely, and bull markets can only last for so long. Sometimes it’s a general shift in sentiment, as in 1929, but usually, some precipitating event occurs.
Numerous things can cause a stock market to crash, including:
- Panic: This is one of the most common contributing factors to a crash. Stockholders who fear the value of their investments are in danger of dropping will sell their shares to protect their money. As prices begin to drop, the fear spreads, more sales ensue, and this can lead to a crash. Anything from a major player in the market having financial trouble to fears about the impact specific legislation may have can cause scores of investors to panic and sell off stock.
- Natural or man-made disasters: These can include all sorts of catastrophes, from floods to wars to pandemics. Case in point: the coronavirus-induced crash of March 2020. As the realization of the spread of COVID-19 began to take hold, the economic outlook for the US and countries worldwide began to look grim. While countries announced travel limitations, mandatory business shutdowns, and quarantines, consumers stocked up on essential supplies causing shortages, companies began protecting profit margins through layoffs and furloughs, and investors started selling off stocks.
- Economic crises: A problem in an industry or one section of the economy often has a ripple effect. One example is the subprime mortgage crisis of 2007-2008. Earlier in the decade, deregulation in the banking industry had led to an increase in mortgages to high-risk borrowers. When these borrowers began defaulting on payments, home prices dropped, and the housing market collapsed. Many of the now-worthless mortgages had been packaged and sold off to institutional investors — who in turn lost billions. Big firms began to fold, and from Sept. 19 to Oct. 10, the Dow Jones Industrial Index declined 3,600 points.
- Speculation: When you have people and companies investing in a sector in the hopes that an asset or security will grow or based on future performance expectations, you have speculation that often creates a bubble. If the performance disappoints, and the hype doesn’t live up to the reality, the bubble bursts, and a mass sell-off occurs.
An example of a stock market crash
Sometimes, crashes are due to several factors. One example is the dot-com crash of 2001.
It started with speculation. A boom of investing in internet companies prevailed through much of the late 1990s. E-commerce was the new economic frontier. Money flooded the rapidly evolving sector, inflating valuations far beyond any profits these companies could ever realistically provide. Venture capitalists swooped in, funding dot-com companies into going public, then quickly cashing out after the firms’ overpriced opening days.
In 2000, the Federal Reserve increased interest rates (partly to stem the overheated investment activity). More fundamentally, the poor financial performance of dotcoms began to surface. Panic set in, investors rushed to sell, and the dotcom bubble burst. The tech-stock heavy Nasdaq Composite index collapsed, eventually falling more than 75% from its March 2000 high of 5,048.62.
The economy fell into a recession. But, while bearish, the stock market held on. Then, disaster struck: The Sept. 11 terrorist attacks in New York City, which shut down the New York Stock Exchange and other exchanges for several days. The two blows — the specter of war, combined with an already shaky economy — caused the stock market to crash when trading resumed on Sept. 17.
The government had to step in with economic stimulus policies before the market, and the economy as a whole, began to recover.
Can a stock market crash be prevented?
There really is no way to prevent the stock market from crashing. However, governments have added safeguards to prevent severe drops and upsets in market stability.
One such tactic is the circuit breaker, instituted after the 1987 crash. If the S&P 500 Index experiences a drop of 7% or more over the previous day, trading in all US stock markets is halted. Depending on the severity of the drop, trading could be suspended for either a 15-minute period or the rest of the day. The purpose of this measure is to give analysts and investors time to gather enough accurate information before making trade decisions.
Large amounts of stocks might also be purchased by private investors to try and stabilize a market. In fact, that used to be quite effective a century ago, shortening the Panics of 1873 and 1907. The government itself can step in, lowering interest rates to encourage investors to borrow and buy.
But even with these mitigating factors, crashes still happen.
What should you do if the stock market crashes?
First thing: Don’t panic and sell out. Yes, it’s hard to hold on and watch your portfolio balance shrink. But unloading when prices are falling is rarely a winning move. Markets tend to shift back over time and you could end up losing money in the long term if you sell when shares are low.
Remember that crashes can be short-lived, and prices may quickly rebound.
This is especially important for older folks or retirees who are looking to live on their investment income or capital gains. They may not have enough time to recoup their losses before needing to use that money for day-to-day expenses. Becoming more anticipatory with market shifts becomes more important the closer you are to this point.
One advance strategy is to ensure that you have a strong mix of defensive stocks in your portfolio. These are securities that are much less influenced by disruptions in the market and tend to be in industries considered to be essential, such as utilities and food. If the market crashes, they may feel some financial pain. However, it will be much less than with cyclical stocks, which are in industries more dependent on a flourishing economy to grow.
If you see economic conditions start to shift toward leaner times, and stocks seem to be entering a prolonged sluggish phase — a bear market — you may want to pull your investment dollars out of the market and place them in a safer financial product that can still earn money. Shifting to CDs or bonds when volatility in the market is getting perilous can be a good move to safeguard your money until things stabilize.
The bottom line
The natural cycle of markets is to rise and fall. While crashes in the stock market can result in crippling losses, economies inevitably bounce back. This makes a strong case for taking a long-view approach to investing. That means creating a strong portfolio that will hold up to dives in market values and provide a healthy mix of securities that will grow when times are good and see you through when times are lean.
Though the thought of a market crash may be scary, recovery will eventually come. You just have to invest carefully to minimize your risks and keep a close eye on economic conditions.