If you have ever been interested in the stock market and the way it works, then you most likely know how volatile and unpredictable it can get.
Stocks are known for having their constant ups and downs, going from the bottom of the Great Recession to new record highs in the blink of an eye. No matter how many stock market crashes we have witnessed throughout history, we still get nervous upon hearing rumors about potential downturns.
But don’t you worry, we’ve got your back: in this article, we tell you what a stock market crash really is, oversee the reasons behind it and suggest several tips on surviving the next market decline.
What is a stock market crash?
With the global economic and political uncertainty of today, it can be rather hard to predict what the future holds. It doesn’t matter whether you are a novice or professional, it’s OK if the term ‘stock market crash’ terrifies you. If history is any example, any market turbulence usually makes almost all investors anxious.
So, what hides behind the term? A stock market crash is a rapid and often unanticipated severe decline of stock prices across a major cross section of a stock market, which results in a substantial loss of paper wealth.
It is typically preceded by a period of economic and political instability, prolonged and high inflation and hysterical speculative activity. If stock market crash history is anything to go by, these always come with widespread misery, bringing stable economic activity to a halt and wiping out the savings of millions of investors all around the world.
There is no specific numerical decline that defines a stock market crash. However, it is important to understand the difference between the term and a stock market correction. Volatility is just another part of the stock market’s life. Prices of stocks and indices rise and fall daily, and markets see turbulent fluctuations over short and long terms.
A stock market crash commonly applies to abrupt double-figure percentage losses in a broad index or many related indices over several days. It is more sudden than a stock market correction, when the market falls 10% over days, weeks or even months to adjust for an overvaluation. For example, each bull market in the past 40 years had a correction as a natural part of the market cycle. On the other hand, stock market crashes are sudden, violent and unexpected. In any case, all market participants usually know when they see one.
Major historical stock market crashes
Sometimes, the best way to get yourself prepared for the future event is to draw lessons from history. The list of the biggest stock market crashes, bubbles and financial crises is rather extensive. However, the most infamous events were the Wall Street crash of 1929, Black Monday in 1987 and the financial crisis of 2008.
The first one, also known as the stock market crash of 1929, refers to the most famous stock market crash of the 20th century, as well as the greatest crash in the history of the US, which eventually led to the Great Depression.
The second, also known as the 1987 stock market crash, refers to the stock market crash that occurred over several days and impacted many stock markets across the world, including New York, London, Hong Kong and Berlin.
What are the causes of the stock market crash?
As we already know, the stock market has crashed several times throughout history. While the exact reason behind each of these events can be quite sophisticated, stock market crashes are generally caused by some combination of several key factors, such as speculation, excessive usage of leverage, rising interest rates and inflation, tax changes, government regulations and political risks. Crashes often occur in a market where price-to-earnings ratios exceed long-term averages, or after an extended period of rising stock prices and excessive economic optimism.
A stock market crash can also be a side effect of the economic crisis, major catastrophic event or collapse of a long-term speculative bubble. These are usually seen as a combination of external economic events with behaviour that results in a herd effect, where selling by some market participants drives more market participants to sell. Therefore, it can be said that frightened sellers cause a crash. Once investors lose confidence, leading to significant sales on a stock exchange, it results in a drop in prices that can trigger a mass sell-off. The increase in the volume of trades also escalates the drop in prices.
With the development of electronic systems and the globalisation of stock markets, crashes can now spread very quickly across the globe, magnifying the collapse of the markets.
How to survive the next stock market downturn
There might be countless articles and features written on “how to” when it comes to a stock market crash survival. However, these can all be irrelevant if an investor doesn’t know how to manage his emotions and feelings. Therefore, if you are wondering how to prepare for a stock market crash – first of all, don't panic when you see one.
Markets can boast of huge swings and volatility, bringing doom-and-gloom predictions from economists and wreaking havoc among all market participants. But you should keep in mind that not every recession comes along with the Great Depression. While it may be tempting to listen to your neighbours, friends, coworkers or talking heads on the TV screen telling you now is the time to panic and sell all of your holdings, it’s better to ignore that advice. Stick to your long-term plan and you’ll be holding a winning hand at the end.
Here are a few things you should consider to survive the next stock market decline:
- Diversify. The best time to work on your asset allocation is before a market crash happens. However, it’s never too late to reconsider your portfolio. It's important to diversify your investments as much as possible and not only through a variety of stocks. Diversify across different asset classes, industries and regions. Owning the right proportion of diversified investments is key to keeping your portfolio’s volatility under control. The way you allocate your portfolio purely depends on your risk tolerance, time horizon and objectives.
- Invest for the long term. Stock markets rise over the long term, often being interrupted by short-term downturns. The rule of thumb is that stock markets fall one-third of the time, recover one-third of the time and rise one-third of the time. So, the more your portfolio is focused on the long term, the better off you’ll be.
- Invest consistently, even during the bad times. Consistent investing allows you to buy stocks when they are at their cheapest. Some of the best times to buy stocks have been when things seemed the worst.
- Invest only what you can afford to lose. While investing is important, so are paying off debts, keeping a roof over your head and eating. Don’t take your short-term funds and invest them in stocks. Think of your long-term needs and never invest money that you can't afford to lose. Remember, stock market crashes can be extremely destructive for those who only think in the short-run.
- Keep your cash on hand. It’s important to have some cash hidden in your pockets during a market crash. First of all, if things turn out sour, and all your investments get wiped off, you will need cash to pay your bills and buy food. Moreover, market declines are great times to pick up deeply discounted securities. Therefore, owning cash allows you to take advantage of the falling market: you can invest it in the good stocks for a bargain.
- Stay on top of financial news. Modern financial markets have full media coverage, allowing you to stay up-to-date with the latest market news. Additionally, there are a large number of tech indicators and tools that can help you to figure out the current trends and patterns.
- Don’t hesitate to ask for help. If you feel that the pressure is overwhelming and you can’t get through it all on your own, it may be the time to talk to your financial advisor before making any impulsive decisions.
At the end of the day, inaction may also be the most effective action of all. Sometimes, not taking any radical steps on selling the stocks and waiting for the storm to get to an end is the best tactic you can implement.
Undoubtedly, there are going to be countless market corrections and crashes throughout your investing career. Stick to your long-term strategy, stay true to yourself and wait for the fog to dissipate. As Victor Hugo said: ”Even the darkest night will end and the sun will rise.”