The Dreaded Stock Market Crash

A crash in the stock market happens when there is a rapid trading of assets in the stock market which causes stock prices to quickly drop.  There is not one single cause to all stock market crashes and many factors influence each crash in a completely different fashion.  However, the performance of the economy is a major influence and affects the sentiment of investors.  In a prosperous and growing economic where the GDP is increasing, investors will generally feel more optimistic and the stock market is less likely to crash.  On the other hand, in a struggling and slowing economy, investors will probably feel less optimistic and began to trade their stocks.  The trading of stocks can spark the start of a stock market crash.  Other factors that can cause the stock market to crash include unemployment, inflation and high interest rates.

Group Mentality of Investors

Although the performance of the economy is one of the most significant indicators of the direction of the stock market, a crash may be caused by a situation which influences a huge trading of stocks and may not be an economic cause at all.  For example, the days after the 9/11 attacks in New York, the stock market fell dramatically because of panic and uncertainty on how the attacks would affect the economy in the future.  This shows how the stock market can crash and nearly every crash is the result of the group mentality of investors – an overwhelming feeling of negativity and panic about the future.  When high level investors get out of the market because of a particular event, other investors are likely to follow and this creates a mad dash to trade away stocks before the prices drop any further when the news spreads.  This type of group mentality is common in single stocks in regular business cycles but during a crash this mentality spreads throughout entire sectors of the economy.

Overpriced Assets

Another variable that may create a situation that influences a stock market crash is the tendency for particular assets to be overpriced because of price speculation.  When investors believe that an asset with become more valuable in the future, they will purchase the asset in hopes of taking advantage of those future gains.  When a large number of investors purchase the same asset with the anticipation of future gains, the demand that is created will raise the price of the asset.  In essence, the investors have created a self-fulfilling prophecy.  When more investors continue to purchase the asset because of its expected strong performance, the price will inflate to the point where it is higher than the actual value of the asset.  Then the price of the asset will reach a point where it is evident that the price is higher than the actual value and investors will respond by quickly trading the asset, causing a drop in price.  This massive trading may create panic and lead to the rapid trading of other assets as well.  As an example, during the economic recession in 2008, oil and real estate prices bubbled and then quickly collapsed.  This affected many sectors of the economy and lead to falling stock prices.

Do you think any other factors create stock market crashes?  What can investors do to protect themselves against stock market crashes?  Please leave your comments below.