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It’s every investor’s worst nightmare: a sudden and steep market decline that wipes out years of gains in a matter of days. They affect everyone from retail investors to professional traders to institutional fund managers to those saving for retirement, to name just a few. Stock market crashes are not that common; they often catch investors by surprise, but when they do happen, they result in widespread losses that spell even further downside—and it can take generations to recover.
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A stock market crash is characterized by a decline of at least 10% over one or several days in a stock market index like the S&P 500, Dow Jones Industrial Average, or Nasdaq Composite.
While no one can pinpoint exactly when a stock market crash will happen, there are several catalysts that could spark the plunge:
Since so much of the market is driven by emotion, any one of these events could cause investors to sell off, and taking cues from each other, their panic rush to offload assets intensifies. While their hope is to prevent further losses, what they wind up doing is driving prices even lower. This is known as capitulation.
During a stock market crash, equity prices collapse over the course of one or a few days. The market decline is rapid. Investors fear the worst and attempt to liquidate their positions, or convert them to cash; oftentimes, this means locking in previously unrealized losses. A stock market crash can be short-lived, or it can take years to recover from, extending into a recession or even a depression.
Investors who have placed large bets using margin (funds they do not own) get particularly hammered during market crashes, as they are forced to face margin calls and thus can experience exponentially greater losses than their original investment. During the 1987 stock market crash, the market’s loss of liquidity was so severe, bid prices exceeded ask prices, and trading became locked at a standstill.
Some of the most well-known stock market crashes are the following:
Fortunately, Wall Street has learned some lessons from stock market crashes of the past, 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 is to ensure the stability of our financial markets. The organization often comes to the rescue with emergency assistance, such as quantitative easing measures, or by lowering interest rates, which drives both growth and stock appreciation.
On the trading floors, during the aftermath of the 1987 stock market crash, circuit breakers were added into trading systems. They temporarily halt trading on stock market indexes whenever there’s a deep decline of 7%, 13%, or 20% based on the previous day’s close.
These circuit breakers are divided into the following thresholds:
Regulators also moved quarterly options expiration, which is known as triple witching, from the morning to the afternoon, since that often results in rapidly accelerating sell orders from large institutional funds.
Market crashes are steep declines that happen over a short timeframe. A market correction occurs over a longer period than a market crash. Market corrections are also categorized by stock index declines of 10%, but their declines take place over an average of 163 days, as measured from 1990. Like market crashes, market corrections can be temporary or have bigger implications, leading to bear markets or worse.
The best thing an investor can do is not get swept up by the hysteria. History has shown that the market always recovers from a stock market crash, even if it takes over 20 years to do so—like it did after the Great Depression, when it took the Dow until 1954 to finally recover from its losses.
Still, the trend for long-term investors, such as 401(k) investors, is always up. That being said, some investors view extreme volatility, even stock market crashes, as an opportunity to buy stocks with solid fundamentals at temporarily reduced valuations.
TheStreet.com’s Luc Olinga says that Michael 'Big Short' Burry keeps making ominous comparisons with this market and 2007's on Twitter.
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