Stock Market Crash: Examples, Cause, Impact

What Not to Do in a Stock Market Crash

stock market crash
Traders work on the floor of the New York Stock Exchange during morning trading on September 22, 2011 in New York City. The Dow Jones industrial average (INDU) dropped 337 points within the first 10 minutes of trading as the global economy struggles and investors continue to lose confidence. Photo by Spencer Platt/Getty Images

Definition: A stock market crash is when stock indexes lose more than 10 percent in a day or two. The broad indexes are the Dow Jones Industrial Average, the S&P 500 and the NASDAQ. The rapidity of the decline differentiates it from a stock market correction. That's a 10 percent loss over days, weeks or even months.

Causes

Traditionally, panicked sellers caused a crash. An economic event, catastrophe or crisis triggers the panic.

That's why investors don't expect a crash and panic. It occurs at the end of an extended bull market. That's when irrational exuberance or greed has driven stock prices to new levels. At that point, the prices are above the real worth of the companies as measured by earnings. For more, see Price to Earnings Ratio.

A new development called quantitative trading caused recent crashes. That's when quant analysts used mathematical algorithms in computer programs to trade stocks. Sophisticated investment and hedge funds with thousands of computers were programmed to sell when certain events occurred. Program trading has grown to the point where it's replaced individual investors, greed and panic as causes of crashes.

Examples

The Stock Market Crash of 1929 kicked off the Great Depression. Over four days, share prices fell 25 percent. It began on October 24, 1929 which is now called Black Thursday.

Stock prices fell 11 percent. These then recovered as 12.9 million shares of stock were sold.  This was triple the usual amount. Trading on Friday seemed back to normal. But the market dropped another 13 percent on Black Monday. This occurred despite the bankers' attempts to stop the panic. The next day, Black Tuesday, the market fell another 11 percent.

The loss of confidence in Wall Street helped kick off the Great Depression. The Dow didn't regain its pre-crash level until November 23, 1954.

The Market Crash of 2008 was signified by the 700-point drop in the Dow on September 29, 2008. It was the largest point drop in the history of the New York Stock Exchange. That was the day the bailout bill failed in the Senate.  This prompted widespread panic after the bankruptcy of Lehman Brothers. Between its peak and its bottom on March, the Dow lost more than 50 percent of its value. It didn't regain its pre-crash level until[JG1] [KA2]  November 23, 1954.

Black Monday, the crash of 1987, occurred on October 19, 1987. The Dow dropped 20.4 percent which is the largest one-day percentage loss in stock market history. It took two years before the market returned to pre-crash levels. The crash followed a 43 percent increase earlier that year. Three factors caused it. First, traders worried about anti-takeover legislation moving through Congress. Second, foreign investors started selling when the Treasury secretary announced he might let the dollar's value fall. Third, quantitative trading programs worsened the losses. Aggressive Federal Reserve monetary policy prevented the crash from causing a recession.

(Source: “10 Greatest Market Crashes,” Marketwatch, October 17, 2012.)  

The Flash Crash occurred on May 6, 2010, when the Dow plummeted almost 1,000 points in just a few minutes. It was a technical malfunction caused by an unexplainable shutdown of quantitative trading programs.

The Dot Com Bubble crashed in March 2000. In 1999, stock prices of high-tech and computer companies were driven up by investors who thought all tech companies were guaranteed money makers. They didn't realize that corporate profits were caused by the Y2K scare. Companies bought new computer systems to make sure their software would understand the difference between 2000 and 1900. Back in those days, only two date fields were needed and not the four required to differentiate the two centuries. The book, Irrational Exuberance, became famous because it explained the herd mentality that created the stock tech bubble in 2000.

 

The Asian Financial Crisis occurred on October 27, 1997. The Dow dropped 554.26 points in response to a 6 percent decline in Hong Kong’s Hang Seng index. The fall in the stock market helped trigger the Long-Term Capital Management crisis.

How It Affects You

Crashes can lead to a bear market. That's stock market decline of 20 percent or more that lasts 18 months. When this happens, a stock market crash can cause a recession.

A stock market crash will make the individual investor sell at rock-bottom prices. How can you tell when the market is about to crash? There's a feeling of "I've got to get in now, or I'll miss the profits," which leads to panicked buying. The individual investor will buy right at the market peak. When investors are driven by emotion, not financials, then that emotion can reverse quickly and turn into panicked selling. That's the symptom of a stock market crash. 

What's the solution? Keep a well-diversified portfolio of stocks, bonds and commodities. Rebalance it as market conditions change. During a crash, stocks should make up less of your portfolio while bonds and commodities should make up more. Sell some of the bonds and commodities to buy more stocks when the prices are down. When they go up again, as they always do, you will profit from the upswing in stock prices. You've sold some of your bonds and commodities, so you won't lose as much when those prices fall during the bull market. Even the most sophisticated investor finds it difficult to recognize a stock market crash until it is too late.