What triggers a Stock Market Crash?

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A lot of people have wondered what triggers a stock market crash and the onset of the economic recession. Many causes can lead to this, but one cannot be determined as the sole cause due to too many factors involved in it.

When I analyze past recessions, most if not all of them started with some sort of shock, either a negative or positive one.

The initial shock caused investors to react by selling their shares at any price, as they did not want to lose any more money than what they already had so that it will later lead to stocks suffering from correction and eventually going down.

What exactly is a crash?

A stock market crash, or stock market panic, occurs when stock markets fall dramatically. Such a drop in prices and widespread sale of stocks may occur over a few days or weeks. 

stock market crash

The price per share dips to an unusually low amount (1/10th of its value), usually over the course of one day, and does not stop at this level for some time after.

Such a drop can occur when all investors decide that certain stocks are overpriced and sell them, or panic selling occurs when there is a loss of confidence in the economy. 

The most recent stock market crash in India took place between February 2020 and April 2020. This was a period of time when investors dumped large amounts of stock because they were worried about the Coronavirus Pandemic.

The causes of a stock market crash:

A Stock Market Crash is caused mainly by:

1)  Over-valuation; 

When a stock’s worth is more than it really should be. This occurs when stocks are overpriced or inflated and their price appreciates unjustifiably.

When prices of certain stocks reach unrealistic levels, the market eventually corrects itself and puts those companies into reality to match their actual worth.

2)   Economy; 

One of the main causes of a stock market crash is an economic downturn. A recession can cause companies to report losses, leading to decreases in share prices and a decline in consumer spending.

When investor confidence plummets, it becomes more difficult for companies to obtain financing, usually resulting in even lower share prices. If this downward spiral continues, it can lead to a stock market crash.

3)  Human Behaviour; 

It seems that human behaviour is the most important cause of a stock market crash. Stock markets are built on trust and confidence between buyers and sellers.

If people do not believe in what they’re doing or if there’s no one to buy their shares, then there is no point in trading because the markets would be empty. And when that happens, the stock market collapses.

4)  Fraud; 

This is one of the least talked about causes, but it’s a big cause of a stock market crash: fraud.

When companies are found to have lied about their own performance or they’re just plain fraudulent, this can send share prices plummeting and create mayhem on Wall Street as investors scramble to get out while the getting’s good.

5)  Corporate Scandals; 

It’s not just smaller companies that get penalised for corporate fraud – gigantic multinationals can suffer as well, and this is a big cause of a stock market crash.

When they’re found out to have broken the rules, it sends shockwaves through the markets because investors simply don’t want to buy shares from a company that doesn’t have integrity.

6)  Insider Trading; 

Insider trading is the practice of buying or selling stocks based on confidential information about the business – typically it’s top employees who sell their shares when they know something bad is happening in the company, and this can cause stock prices to plummet and an eventual stock market crash.

7) Foreign investors; 

Foreign investment is usually done through large companies, known as ‘investment banks’. When these large foreign investment firms make bad choices on the stock market, it affects their stocks’ values.

Then, these foreign investment firms sell off their holdings in panic. This causes the prices of certain stocks to drop rapidly. Other investors follow suit and begin selling their own shares at a loss until no one wants them anymore because they are considered ‘worthless’.

Some other causes for the stock market crash are :

  • Fear of the depreciation of currencies due to inflationary pressures: This is one more reason of a stock market crash, when investors lose faith in their currency and it begins to drop in value against other currencies (i.e., on foreign markets).
  • Political and governmental instability. Whenever there are frequent political changes and scandals in countries, this may have an impact on the capitalization of stock markets.
  • An increase in the cost of raw materials, energy or foodstuffs caused by natural disasters. If there are any natural calamities like hurricanes or floods, the prices of essential goods and commodities will increase on a global market due to lack of sufficient supply.
  • Disinformation and rumors about possible economic decline, which cause panic in the markets: When investors hear rumors about a possible economic decline of a country or region, they may stop buying shares on the stock exchange market (i.e., selling their stocks), thus causing financial problems for most companies and corporations.

What to do when a stock market crashes?

Stock market crashes are not an everyday occurrence, but that does not mean they never happen; in fact, there have been dozens of stock market crashes throughout history.

Although it is impossible to predict when, where and how long the next stock market crash will come about, there are actions that you can take to reduce its effects on your life.

Although nothing can guarantee that you will not lose money in an economic downturn but you can reduce the impact of a crash by buying a Put Option.

One common measure that people use to protect themselves from a stock market crash is to buy a put option.

Put Options provide hedging against your portfolio, or part of your portfolio, and have historically been a very effective way to protect against crashing stock.

The most important aspect of this is that your Put Option will increase in value if the market falls. In this way, you can protect yourself from an economic downturn by earning a profit instead of enduring a loss.

When a Stock Market Crash occurs, analyze why it crashed and figure out how to prevent it from happening again by looking at what caused its downfall to begin with.

Learn from the mistakes of those who have fallen before you so that you may be able to rebound nicely after the market crashes. Those who don’t will fall again and lose even more money.

Strategies for investing during and after a crash:

One of the most common questions we hear is how to invest in a down market. The internet is filled with various strategies, but which are the best?

There are really three basic approaches to investing:

  1. Defensive Strategy,
  2. Offensive Strategy, and
  3. Wait and See.

(1) Defensive Strategy

The most widely used approach by individual investors and professional fund managers is the defensive approach. This strategy involves using stock market timing indicators to try and determine when a bear market is about to start or is already in progress.

If the indicators show that a crash is imminent, defensive investors will sell their stocks before the market drops too far.

This strategy requires staying up late watching for news reports and analyzing charts on your computer screen, trying to interpret whether the markets are likely to bounce back soon or continue dropping.

If you’re not an investing guru or have some sort of crystal ball, this kind of strategy is bound to fail.

It doesn’t take long for novice investors to become very frustrated trying to figure out which direction the market is heading next and it’s very easy to make a mistake that will cost you money.

This strategy also takes a lot of time and effort to keep up with, which is why you’ll find very few people using it in practice.

Successfully implementing this kind of strategy requires being on top of the market news flow, which can be quite costly if you have to pay someone else for that kind of information service.

(2) Offensive Strategy

The offensive strategy is based on the philosophy that stocks always go up in the long run, so you should buy and hold as much as you can afford. The only time you sell is when prices have blown through your target price, at which time it’s best to take profits and move into cash.

This approach has the advantage of not requiring you to watch the market daily or look for warning signals of an impending crash. Instead, you simply buy and hold until your target price is reached, at which time you sell only if the market continues rising.

The disadvantage of this strategy is that it can be very costly if most of your investments are in stocks at the start of a major crash.

If you recently have been adding to your stock holdings in anticipation of continued growth, it can be very difficult (if not impossible) to sell in a market that is dropping faster than you anticipated.

If you are only partially invested in stocks, you may be able to take profits early before prices drop too far. You can then use the cash proceeds from your stock sales to buy more stocks at lower prices later.

(3) Wait and See

A third, alternative investment strategy is to wait for the bottom of the crash before deciding whether to invest or not.

If you are already invested in stocks, this means keeping your funds in cash until prices stabilize or start moving up again. Once a rebound starts, you can use your cash reserves to buy more stocks at lower prices.

The advantage of this approach is that it involves the least amount of work and money. You don’t have to watch the market daily or make any trades unless prices start moving in your favour.

When the markets finally rebound, you will be able to buy back into stocks at lower prices than you originally paid for them.

In general, this strategy makes the most sense for defensive investors using high-quality safe stocks that are unlikely to plummet by 50% or more in a downturn.

The problem with this approach is that it requires you to sit on the sidelines until the markets rebound, which can be quite costly if the market drops much lower than expected.

The one advantage of this approach is its simplicity, but it also comes with the disadvantage of potentially missing out on substantial gains in an eventual rising market if you have to wait for a few years until prices stabilize or start moving up again.

The bottom line is that all three strategies are based on different approaches and philosophies, so each one has strengths and weaknesses.

If you are starting new investments for the first time, you may want to consider using a mix of these three strategies.

One thing investors cannot do is predict with a high degree of certainty whether there will be another stock market crash in the future.

However, we do know that it’s best to have an investment plan ready before a downturn begins so you can respond quickly without having to make any major changes if stocks begin dropping again.

The best way for investors to protect themselves from another stock market crash is to remain fully diversified. This includes having a mix of Quality dividend-paying blue-chip stocks, Low-risk bonds such as Treasuries or high-quality municipal bonds Real estate in specific areas you are familiar with.

However, if you are out of all of these investments and waiting for another crash, it’s important to keep in mind that even a high-quality stock or bond might go down 50% during a downturn.

Consequently, investors who already own stocks will need to either bear losses until prices rebound or consider using the defensive strategy outlined above.

Who are some of the people who benefit from these crashes:

Once a Stock Market Crash occurs, it is immediately followed by an economic recession, which is usually followed by a depression. Companies that survive the crash will be the ones who have many investors on their side and giving them money to invest in.

Those who lose everything in Stock Market Crashes tend to learn from these experiences, and some of them even go on to become extremely successful investors after they lose it all.

Here are a few examples of people who have become successful investors and experts in the Stock Market after suffering terrible losses during past crashes: 

  • Warren Buffett  
  • George Soros
  • Yasuo Hamanaka

The lesson to learn from the experiences of these investors after Stock Market Crashes is that you must be aware of anything new in any industry, even if it’s very risky or far from your knowledge base. 

It might not pay off right away, but there are sure to be changes in the market that will allow for long-term profits to be earned by anyone who is well informed about such changes.

Investing in Stocks  even if they’re risky investments:

If you ever want to become financially independent or build wealth, then investing in stocks should be part of your plan.

There are no guarantees in any investment strategy, but if you understand the basics of investing and can learn from past Stock Market Crashes, then you are almost guaranteed to become an investor who earns a high return on investment.

Investing in stocks is not for everyone because they’re risky investments that involve higher prices when compared to bonds or other safe investments.  If you own stocks, you must be prepared for any scenario that could destroy the value of your investment.

You should also be careful about the company’s financial standing and how well they are doing in the market because even if you have a good understanding of investing, you can still get crushed by a Stock Market Crash. 

Don’t try to time, crashes or use them as the basis for your investment strategy because they are not predictable.

The best thing to do is to write a list of companies that interest you and research their value over time.  Read up on their financial standing, liquidity, debt loads, earnings reports, and events that could affect the company’s prospects. 

If you see anything that concerns you, then don’t invest in their stocks.  If the company has strong fundamentals, however, then buy their stock at a price that is low enough to allow for an easy profit.

Never put more than 5% of your investment portfolio into any one company. You should also diversify your investments into different industry sectors and different market capitalization levels, as well as multiple currencies abroad. 

The more diversified you are, the less risk you have because if one company crashes, then it will not necessarily cause a crash that destroys all of your investments.

Learn from past Stock Market Crashes:

The best way to prepare for future market crashes is to learn from past events, which may include 1992 the Harshad Mehta scam, the financial crisis of 2008 or the covid-19 Pandemic in 2020.  

Books about famous investors such as George Soros can help you understand what goes on inside the mind of a successful investor and how they handle their investments during a market crash. 

Become an active investor by reading up on investing and learn as much as you can about the financial sector so that you’re prepared to take advantage of any future opportunities, even if they require a lot of risks because you should never let fear stop you from getting ahead in life.

You should also have a long-term investing strategy that balances risk vs reward and keep your eyes open for what is going on in the world. 

You may be able to make an easy profit by investing in companies that will benefit from future changes, even if it’s not direct competition to their products or services.

If you want to become financially independent later in life, then you should look at companies that have a lot of cash on hand and are making products or offering services that will be needed over the long term.  You can make an easy profit by investing in such companies because their stocks may appear to lack value at times, but they’re actually still growing.

Conclusion:

The stock market is risky by nature. That’s why it can be scary when you hear that the Indian stock market has crashed or some other major company just filed for bankruptcy protection. 

But if we look at how past crashes have played out, there are many lessons to learn about investing in stocks even during times of uncertainty and risk. 

I hope this blog post has helped you understand what a crash is all about and give you some insights into how they happen, who benefits from them, and ways to invest more intelligently while navigating these turbulent waters. 

Do you have any regrets about what you did during the 2020 stock market crash? Let me know in the comments below! 

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I'm a Blogger, Writer, and speaker. In my blog, I talk about things that work in real.

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