What is a stock market crash? Causes, examples and lessons learned
What is a stock market crash?
It’s every investor’s worst nightmare: a sudden, steep market decline that wipes out years of gains in days. They affect everyone, from retail investors to professional traders, institutional fund managers and those saving for retirement, to name a few. Stock market crashes are not that common; they often catch investors by surprise, but when they happen, they lead to widespread losses that lead to an even bigger drop – and sometimes it takes generations to recover.
A stock market crash is characterized by a drop of at least 10% over one or more days in a stock market index such as the S&P 500, the Dow Jones Industrial Average or the Nasdaq Composite.
What are the causes of stock market crashes?
Although no one can pinpoint exactly when a stock market crash will occur, several catalysts could trigger the plunge:
- Rampant speculation can lead to overvalued stock prices and the formation of asset bubbles. This happened with mortgage-backed securities at the end of the years and led to the financial crisis of 2008.
- After a long period of economic growth, equities could show high price-earnings valuations relative to long-term averages. P/E ratios often peak before a downturn; many analysts believe this was a factor in the Black Monday crash of 1987.
- There could be a sudden and catastrophic event, such as a supply shock or a natural disaster, like what happened at the start of the COVID-19 pandemic in March 2020.
- And then there are those causes that are not so easy to identify: they are simply the result of poor market sentiment resulting from deteriorating economic conditions, such as during a bear market.
Since much of the market is driven by emotion, any of these events could cause investors to sell off, and taking inspiration from each other, their panic rush to get rid of assets. intensifies. While they hope to avoid further losses, they end up driving prices down even further. This is called capitulation.
How does the stock market crash? Where does the money go?
During a stock market crash, stock prices plummet within a day or a few. The decline of the market is rapid. Investors fear the worst and try to liquidate their positions or convert them into cash; often this means locking in previously unrealized losses. A stock market crash can be short-lived, or it can take years to recover, extending into a recession or even a depression.
Investors who have placed large bets using margin (funds they do not own) are particularly hard hit during stock market crashes, as they are forced to face margin calls and can therefore suffer exponentially greater losses. larger than their initial investment. During the stock market crash of 1987, the loss of market liquidity was so severe that bid prices exceeded ask prices and trading stalled.
What are the biggest stock market crashes? What was the worst?
Some of the most well-known stock market crashes are:
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- The Wall Street Crash of 1929 was the worst. The Dow Jones fell 23% in two days, triggering the Great Depression.
- During the Black Monday stock market crash of 1987, the Dow fell 22.6% in one day.
- In the aftermath of the September 11 terrorist attacks, the S&P 500 fell 14% in one week in September 2001.
- The 2008 financial crisis, which was fueled by the US housing market bubble, saw the S&P 500 fall 20% in one week in October 2008.
- During the 2020 global pandemic, the Dow Jones fell 12.9% in one day on March 16, 2020.
How to prevent stock market crashes?
Fortunately, Wall Street has learned some lessons from past stock market crashes, particularly those of the early 20th century, which caused bank runs and threatened the collapse of our entire economy. These panics led to the formation of the Federal Reserve, whose job it is to keep our financial markets stable. The organization often comes to the rescue with emergency assistance, such as quantitative easing measures, or by lowering interest rates, which stimulates both growth and stock appreciation.
On trading floors, in the aftermath of the 1987 stock market crash, circuit breakers were added to trading systems. They temporarily halt stock index trading whenever there is a sharp drop of 7%, 13% or 20% based on the previous day’s close.
These circuit breakers are divided according to the following thresholds:
- Level 1 and Level 2: In the event that an index drops by 7% or 13%, trading stops for 15 minutes if the drop occurs before 3:25 p.m.
- Level 3: In the event that an index falls by 20% at any time during the day, trading stops for the rest of the day.
Regulators have also moved the quarterly options expiration, known as the triple witch, from morning to afternoon, as it often leads to a rapid acceleration of sell orders from large institutional funds.
What is the difference between a fix and a crash?
Stock market crashes are steep declines that occur over a short period of time. A market correction occurs over a longer period than a stock market crash. Market corrections are also categorized by declines in stock indices of 10%, but their declines occur over an average of 163 days, measured from 1990. Like stock market crashes, market corrections can be temporary or have implications larger, leading to bear markets or worse. .
How can I protect my 401k from a stock market crash?
The best thing an investor can do is not get caught up in the hysteria. History has shown that the market always recovers from a stock market crash, even if it takes more than 20 years to do so, as it did after the Great Depression, when it took the Dow Jones until in 1954 to finally recover from his losses.
Yet the trend for long-term investors, such as 401(k) investors, is still on the rise. That being said, some investors view extreme volatility, or even stock market crashes, as an opportunity to buy stocks with strong fundamentals at temporarily reduced valuations.
Is the stock market collapsing? Will it crash in 2022?
Daniel Kline of TheStreet.com admits inflation has been real so far in 2022, but he’s not worried about a stock market crash.