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Stocks Trading

Stock market crash: previous events and lessons to learn

Market crash image representation with traders looking at numbers crashing in charts

Stock market crashes: lessons to learn

The stock market has always been a roller coaster ride, with ups and downs that can make even the most experienced investors feel queasy. While no one can predict when the next crash will occur, it's important to learn from past events. In this post, we'll take a trip down memory lane and explore some of the most significant stock market crashes in history. Along the way, we'll uncover valuable lessons that can help you protect your investments in such uncertain times.

What is a stock market crash?

A stock market crash is like a thunderstorm that comes out of nowhere, shaking the financial world to its core. It refers to a rapid and severe drop in the prices of stocks, bonds, or other financial instruments traded on the stock market. It is usually accompanied by a widespread panic among investors, leading to a sell-off of stocks and a further decline in prices.

It can have significant economic consequences, including a decline in consumer spending, business closures, and even a recession. Crashes can be caused by a variety of factors, including economic downturns and geopolitical events, as you’ll see shortly.

What are the reasons behind stock market crashes?

There are several reasons why a stock market crash may occur. Here are three common causes:

  1. Speculative Bubbles: A speculative bubble is a situation where the prices of certain assets, such as stocks or real estate, rise to levels far beyond their fundamental value. This can happen when investors become overly optimistic about the future prospects of an asset and buy in, leading to a self-reinforcing cycle of rising prices. Eventually, the bubble bursts, and prices collapse, leading to a stock market crash.

The dot-com bubble in the late 1990s is a classic example of a speculative bubble. Investors became convinced that internet-based companies would transform the economy and invested heavily in them, leading to a massive run-up in stock prices.

However, when the bubble burst, many of these companies went bankrupt, and investors lost significant amounts of money.

  1. Geopolitical Crises: Wars, political instability, and other geopolitical events can create uncertainty and volatility in financial markets. These events can impact global trade, disrupt supply chains, and lead to changes in government policies that can impact corporate earnings. Investors may react to this uncertainty by selling stocks, leading to a stock market crash.

Example: The 2008 financial crisis was triggered by a combination of factors, including the collapse of the housing market and the failure of several large financial institutions.

However, the crisis was also exacerbated by geopolitical events, such as the Iraq War and the Russian invasion of Georgia, which increased global uncertainty and contributed to the stock market crash.

  1. Black Swans: A Black Swan event is a rare, unexpected event that has a significant impact on financial markets. These events are difficult to predict and can cause widespread panic and selling.

The COVID-19 pandemic is a recent example of a Black Swan event that triggered a stock market crash. As the pandemic spread globally, businesses shut down, and supply chains were disrupted, leading to a sharp decline in corporate earnings.

Investors panicked and sold off stocks, leading to a significant decline in the stock market.

Previous stock market crash events

Event Cause Effect Lesson
The Great Depression crash of October 1929 The stock market crash of 1929 was primarily caused by the speculation and over-investment in the stock market during the Roaring Twenties, which created a bubble that eventually burst. Additionally, there were other underlying economic problems such as overproduction, unequal distribution of wealth, and excessive use of credit. The Great Depression that followed the stock market crash of 1929 was one of the most severe and prolonged economic downturns in history. The stock market lost 80% of its value, banks failed, unemployment soared, and thousands of businesses closed. It took over 2 decades for the economy to recover. This crash demonstrated the importance of sound economic policies and regulations to prevent over-speculation and over-investment in the stock market. It also showed the need for government intervention to stabilize the economy during times of crisis.
The Black Monday crash of October 1987 The Black Monday crash was caused by a combination of factors, including program trading, which involved the use of computer algorithms to automatically execute trades, and a lack of liquidity in the market. Additionally, there was a general sense of uncertainty and fear in the market, which led to panic selling. It was the largest one-day percentage decline in stock market history, with the US30 Industrial Average falling by 22.6%. The crash had a ripple effect on the global economy, with stock markets around the world experiencing declines. However, the market recovered relatively quickly and did not lead to a prolonged economic downturn. The Black Monday Crash highlighted the risks of program trading and the importance of maintaining liquidity in the market. It also demonstrated the importance of having circuit breakers in place to prevent excessive volatility and panic selling.
The Dot-com crash of 2000-2001 The Dot-com crash was caused by a speculative bubble in technology stocks, fueled by over-investment and unrealistic expectations about the potential of the internet and related technologies. Many companies with little or no revenue were valued at billions of dollars, and investors poured money into these companies despite their lack of profitability. This crash resulted in a significant decline in technology stocks, with the SPX500 dropping nearly 50%. Many dot-com companies went bankrupt, and the technology sector took several years to recover. The Dot-com crash highlighted the importance of investing in companies with sound fundamentals and a clear path to profitability. It also showed the need for caution when investing in speculative or overvalued markets.
Stock Market Crash of 2007/08 The stock market crash of 2007/08 was caused by a combination of factors, including the subprime mortgage crisis, a decline in housing prices, and the failure of large financial institutions. Additionally, there was a general lack of oversight and regulation of the financial industry, which contributed to the crisis. The crash resulted in a severe recession, with unemployment reaching a high of 10%. The housing market also experienced a significant decline, with many homeowners facing foreclosure. The government implemented a series of measures to stabilize the economy, including a bailout of several large financial institutions. This crash highlighted the importance of effective regulation and oversight of the financial industry. It also demonstrated the risks of investing in complex financial instruments and the need for transparency in financial transactions.

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How to prepare for a stock market crash

Circuit breakers and plunge protection are just some of the measures that can be taken to mitigate the impact of a stock market crash. Here's how they work:

Circuit breakers:
These are mechanisms that halt trading in the event of a significant market downturn. The purpose of circuit breakers is to give investors time to reassess their positions and prevent panic selling. Different exchanges may have different rules for circuit breakers, but typically, trading is halted for a set period of time if the market falls by a certain percentage.

For example, on the New York Stock Exchange, if the SPX500 index falls by 7% before 3:25 pm, trading is halted for 15 minutes. If the drop occurs after 3:25 pm, trading is allowed to continue until the close of the market.
Plunge protection:
This refers to actions taken by central banks or governments to stabilize financial markets during a crisis. The goal of plunge protection is to prevent a market crash from turning into a full-blown financial crisis.

For example, during the 2008 financial crisis, the US Federal Reserve implemented a number of measures to support the financial system, including lowering interest rates, injecting liquidity into the markets, and providing guarantees for certain types of investments. The hope is that these actions will restore confidence and prevent panic selling.

It's important to note that while circuit breakers and plunge protection can help mitigate the impact of a stock market crash, they are not foolproof solutions. It's still important for investors to have a diversified portfolio and a long-term investment strategy to weather market fluctuations.

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Stock market crashes are a part of the financial landscape, and while they can be frightening and painful in the short term, they can also provide valuable lessons for investors. By studying previous market crashes, we can learn how to prepare for and potentially mitigate their impact, such as through diversification, long-term investing, and understanding mitigation strategies such as circuit breakers and plunge protection.

Past performance does not guarantee or predict future performance. This article is offered for general information purposes only and does not constitute investment advice.