In this article, we will cover the definition of a financial market collapse, its causes and effects, as well as how to protect yourself from it. The article is divided into subsections that are placed under
headings, where a brief description of each subsection is provided.
What are the causes of a financial market collapse?
A simple definition of the causes of a financial market collapse.
The cause of a market collapse lies in fearful sellers.
Crises and unexpected economic events trigger panic responses. For example, the market collapse in 2008 began on September 29, when the Dow Jones index dropped by 777.68 points, marking a significant decline after the New York Stock Exchange ever. The panic of investors came after Congress failed to approve the bank rescue bill. They feared that more financial institutions would bankrupt like Lehman Brothers.
A collapse usually occurs at the end of a long bull market. At that time, excitement and greed push stock prices to unsustainable levels. During this time, prices are above the real values of the companies as measured by earnings.
The new technological development known as “quantitative trading” has caused recent collapses. “Quantitative analysts” use mathematical algorithms in computer programs to trade stocks. Program trading has grown to the extent that individual investors’ greed and panic have been replaced as causes for fluctuations.
Effects of financial market collapse
The effects of collapses include a transition to a bear market. When markets drop by 10% for more than a fully corrected 20% or more. A financial market collapse can also lead to a recession.
Stocks are an important source of capital used by companies to manage and grow their businesses. If stock prices drop significantly, companies have less capacity to grow. Companies that are not producing will eventually lay off employees to remain sustainable. With layoffs, spending decreases. The drop in demand means less revenue, which means more job cuts. As the decline continues, the economy contracts, creating a critical situation.
In the past, financial market collapses preceded the Great Depression, the recession of 2001, and the Great Recession of 2008.
What not to do during market collapses
You should not be swept away by the desire to sell during a collapse. It’s like trying to catch a falling knife. A market collapse will cause individual investors to sell at low prices. This is exactly the wrong thing to do. Why?
Most of the time, the financial market adjusts to losses in the months following the collapse. As the market heads upward, sellers fear they will miss the opportunity to buy back. As a result, they close their losses. If you sell during a collapse, you may not buy back in time to recover your losses.
Your best option is to sell before the collapse. How can you know when a market collapse will occur? There is a sense of “I have to get into the markets now, or I will miss the profits,” leading to panic buying. However, most investors end up buying at the market’s peak, with emotions rather than financial information driving them.
What is the solution? Keep a diversified portfolio of stocks, bonds, and commodities.
Protecting yourself through rebalancing
Rebalance your portfolio according to changing market conditions. If you have done well, you may have sold stocks after their values rise. If the economy enters a recession, continued rebalancing means you will buy stocks when prices are low. When they rise again, as has happened in history, you will benefit from the increase in stock prices.
Continuous balancing of a diversified portfolio is the best way to protect yourself from a collapse. Even the most sophisticated investors find it challenging to recognize a financial market collapse until it is too late.
Gold
It Can Be Preventive
Gold may be the best protection against the possibility of a financial market crash. A study conducted by researchers at Trinity College showed that gold prices rose significantly for 15 days after a crash. Panic-stricken investors sold their stocks and bought gold. After the first 15 days, gold prices lost value against stocks, and investors regained money in stocks due to their lower prices. Individuals who held onto gold after the 15 days began to lose money.
Most financial planners will tell you that the best protection during tough times isn’t gold or any other single asset. Instead, you should have a diversified portfolio that meets your goals. Asset allocation should support those goals.
Frequently Asked Questions
When will the real estate market crash?
While many analysts try to predict it, no one can say for sure when the real estate market (or any other market) will crash. You can look for warning signs in the markets. For example, with the real estate market, an analyst might want to track statistics such as the mortgage delinquency rate.
Why did the cryptocurrency market crash?
The cryptocurrency market crashes for the same reason that any other market crashes. The crash is usually the result of extreme fear that leads to a sudden sell-off. Typically, there is an unexpected event that contributes to increased fear in the markets.
Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in its articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Charles Schwab. “Stock Market Correction: What Does It Mean?”
S&P Dow Jones Indices. “Dow Jones Industrial Average, Download Daily DJIA Performance History.”
Tom Lynn. Review of California Law Review 678 (2013).
Security and Exchange Commission. “Testimony on the Severe Market Disruption of May 6, 2010.”
Roger Farmer. Journal of Economic Dynamics and Control. “The 2008 Stock Market Crash Led to the Great Recession: Theory and Evidence.”
Derek Pearce and Brian Lucy. Trinity College Dublin. “Is Gold a Preventive or a Safe Haven? An Analysis of Stocks, Bonds, and Gold.”
Source: https://www.thebalancemoney.com/stock-market-crash-examples-cause-impact-3305864
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