We have all seen what happens when a market crashes. Whether it’s the dot-com bubble, the 2008 housing crisis, the substantial weekly dips in the cryptocurrency price, or even the recent stock market correction, these market movements can be both scary and exciting. Millions of people have been affected by market crashes, and one of the biggest fears for an investor is whether they are getting into the market at the right time.
Not all market crashes are dire, however. Depending on what causes them, these crashes can be very healthy for the market. To see why it helps to find out what causes a market to crash in the first place.
In this post, we will look at some of the main factors that influence the way a market moves and see a couple of examples.
The Stock Market
Since the stock market is the most famous market, and our primary focus at Stockpile, let’s start there.
A stock market crash can be defined as a rapid and sometimes unanticipated drop in the price of stocks. This can result from many things, including environmental disasters, political events, earning reports, media hype, and more. However, at the most basic level, the price of a stock will drop when the majority of sell orders are set below the current market price. For example, if a share is steady at $100, and a large number of shareholders put up sell orders for $80, then the price would start to decrease.
So what are some of the main factors?
- Mass Psychology – When thinking about markets of this scale, it makes sense to think of how people themselves think. After all, investors make individual decisions, which will move the market in either direction. When a market crashes, one of the leading reasons is panic selling. Panic selling occurs when a significant amount of shareholders sell large quantities of their holdings for whatever reason. Sometimes it is because of the company’s performance, or it can be something as trivial as the CEO making a controversial tweet. Whatever the case is, when a significant portion of these individuals panic, it can lead to a sharp decline in stock prices.
- Healthy Correction – When investors are optimistic and have a lot of money to spend, sometimes a market may become slightly overvalued. In these situations, it is common for there to be a correction, where people gain a more realistic understanding of the actual value of a stock. Some would say that the stock market is currently overvalued, and we have seen some slight corrections in the past weeks, but only time will tell. In fact, in 2017, there was tremendous growth across various exchanges and indexes. The Dow industrial average, for example, went up 25%, the S&P 500 was up 19%, and Nasdaq saw an incredible 28% increase. This amount of growth is a good thing but may also be the result of an overvalued market.
- Politics – One reason why there was this amount of growth over the past year had to do with the change in policy surrounding corporate taxes. The new tax bill that was passed by President Trump made it so corporations would pay only 20% in taxes instead of 35%. This would have noticeable impacts on a company’s profits and would lead to higher stock value. On the other hand, if similar legislation were passed that raised taxes, we would see the exact opposite effect. The political activities of a government can boost or crash a market.
Examples of Market Crashes
Another way to better understand what causes a market to crash is by looking at crashes in the past. The dotcom bubble is one of the most famous market crashes of our time. In the mid and late 1990s, a company’s value could skyrocket by merely adding a website to their collection of products or services. The internet had enormous hype surrounding it, and this blinded investors. By the end of 2001, most of the publicly traded dot-com companies utterly failed. One famous example is pets.com.
Another famous crash in history was the tulip bubble. This was due to the vast demand for Dutch tulip bulbs during the 1630s. This was a purely speculative bubble fueled by the mass desire to make quick and significant profits. People would trade tulip bulb futures continually with the hope it would continue to rise with the hype. Ultimately, the hype died down, and people realized that the market value was nowhere near the real amount.
Several factors can cause a market crash, but the main denominator is always the psychology behind the investors who are buying and selling. To be the most active investor, you have to always look through your available resources to make an educated guess on how you think people will behave collectively. By being inquisitive, analytical, and proactive, you have a much higher chance of avoiding negative impacts from a market crash.