Stock Market Crash

A drastic, often unforeseen, drop in the prices of stocks in the stock market

What is a Stock Market Crash?

A stock market crash refers to a drastic, often unforeseen, drop in the prices of stocks in the stock market. The sudden drop in stock prices may be influenced by economic conditions, catastrophic event(s), or speculative elements that sweep across the market.

 

Stock Market Crash

 

Most market crashes are usually short bursts of market downturns that can last for a single day or much longer to bring investors heavy losses. Popular examples of stock market crashes include the 1929 stock market crash, 1987 October stock market crash, and the 2020 COVID-19 stock market crash.

 

Summary

  • A stock market crash occurs when the market’s entered an unstable phase, and any slight disturbance causes share prices to fall suddenly and unexpectedly.
  • Some of the common stock market crashes in the U.S. occurred in 1929, 1987, 1999-2000, 2008, and 2020.
  • Following a stock market crash, panic trading can be prevented by triggering market-wide circuit breakers or adopting plunge protection.

 

Understanding Market Crashes

There is no conventional way of describing a market crash, but the term commonly applies to an abrupt decline in the stock market index over a single or several days. Stock market crashes have severe effects on the economy and investors’ behavior. Essentially, the overall economy of a country depends on its stock market.

A country’s stock market trend becomes the main focus when investors intend to invest. The most common ways investors are bound to lose their money in the event of a stock market collapse is when they sell shares following a sudden drop in market prices and purchase many shares before a market crash. Consequently, a market crash causes stock market investors to lose a huge value of their investments, and their confidence in the security market is severely affected.

 

Records of Stock Market Crashes

Historically, a stock market crash can be traced back to the Republic of the Netherlands between 1585 and 1650, when contract prices for bulbs and fashionable tulips became exceptionally high. The beautiful colors and scarcity of tulips made them in high demand among society’s upper class.

The actual production process was not delivering profits during the build-up of the tulip market. It was speculated that the price of tulips determined the wealth of market participants and, in turn, created a high demand among the Dutch elite.

As the frenzy continued, more people, including the middle class, invested in the tulip business. They mortgaged their businesses and properties to trade in tulips. However, as interest in tulips waned, the price lost all correlation to its comparative value with other products, bankrupting speculators who initially assumed that the craze would last forever. The unexpected market collapse sent the Dutch economy into depression.

 

Common Stock Market Crashes in the U.S.

The U.S. experienced a fair share of stock market crashes in the past, including:

 

The Great Crash of October 1929

This was the first major U.S. market crash, where speculations caused share prices to skyrocket. There was a growing interest in commodities such as autos and homes. Uninformed investors flooded the market, driving up panic selling. They slid into bankruptcy when the market bubble popped.

 

The Crash of October 1987

The October 1987 market crash became known as Black Monday and is attributed to computer trading, derivative securities, over-evaluation, illiquidity, and trade and budget deficits. As a result of the crash, major market valuation indexes in the U.S. declined by at least 30%.

 

The Dot.com Crash of 2000-2001

As with the Crash of October 1987, the 2000 dotcom market collapse was triggered by technology. Investors’ interests in internet stocks increased to a high level following repeated sessions of trading. The accurate valuation of high-tech companies saw the recovery of the Dot.com Crash.

 

Stock Market Crash of 2007/08

The 2007/08 stock market crash was triggered by the use of mortgage-backed securities in the housing sector. The high frequency of speculative trading caused the securities decline in value as housing prices receded. With most homeowners unable to meet their debt obligations, financial institutions slid into bankruptcy, causing the Great Recession.

 

The Crash of March 2020

The market collapse in March 2020 was caused by the government’s reaction to the Novel COVID-19 outbreak, a rapidly spreading coronavirus around the world. The pandemic impacted many sectors worldwide, including healthcare, natural gas, food, and software. The unemployment rate skyrocketed in the first quarter of 2020.

 

How to Prevent a Stock Market Crash

During stock market crises, panicked stockholders tend to sell their assets to cushion them from losses. Several safeguards are in place to curb heavy losses that suffice due to panic trading. Some of the responses include the following:

 

1. Circuit Breakers

Current guidelines by the U.S. Securities and Exchange Commission (SEC) mandate market-wide a 15-minute pause on all stocks traded in the U.S. in hopes the market will calm. The circuit-breaker approach is rendered effective if the S&P 500 falls more than 7% before 3:45 p.m. EST.

The circuit breakers are triggered to stop trading as it gets more volatile. Levels 1 and 2 market-wide circuit breakers suspend trading for 15 minutes, while level 3 halts trading for the rest of the day.

 

2. Plunge Protection

Turbulent markets can also be lessened by preventing panic selling through the purchase of massive quantities of stocks by large entities. By so doing, established entities set the stage for individual traders to stop panic trading. One risk associated with the method is its ineffectiveness.

 

Related Readings

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • 2008 Global Financial Crisis
  • 2010 Flash Crash
  • Panic Buying
  • The Economic Crash of 2020

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