What Is a Stock Market Crash?

Its Causes, Effects, and How to Protect Yourself

Image shows how to protect yourself against stock market crashes. Don’t give in to the temptation to sell your stocks Keep a diversified portfolio of stocks, bonds, and commodities Invest in gold

Image by Theresa Chiechi © The Balance 2020

A stock market crash is when a market index drops severely in a day, or a few days, of trading. The indexes are the Dow Jones Industrial Average, the S&P 500, and the Nasdaq.

A crash is more sudden than a stock market correction, which is when the market falls 10% from its 52-week high over days, weeks, or even months. Each of the bull markets in the last 40 years has had a correction (and often several). It's a natural part of the market cycle that wise investors welcome. Such a pullback allows the market to consolidate before going toward higher highs.

No one welcomes a market crash because they are sudden, violent, and unexpected.

Market Crash Causes

To put it simply: Frightened sellers cause market crashes.

An unexpected economic event, catastrophe, or crisis triggers the panic. For example, the market crash of 2008 began on Sept. 29, 2008, when the Dow fell 777.68 points. It was the largest point drop in the history of the New York Stock Exchange at that time. Investors panicked when Congress failed to approve the bank bailout bill. They were afraid more financial institutions would go bankrupt the way Lehman Brothers had.

Crashes generally occur at the end of an extended bull market. That's when irrational exuberance or greed has driven stock prices to unsustainable levels. At that point, the prices are above the real worth of the companies as measured by earnings.

A new technical development called quantitative trading has caused recent crashes. "Quant analysts" use mathematical algorithms in computer programs to trade stocks. Program trading has grown to the point where it's replaced individual investors, greed, and panic as causes of crashes.

An example is the flash crash that occurred on May 6, 2010. The Dow plummeted almost 1,000 points in just a few minutes. Quantitative trading programs were shut down due to a technical malfunction.

Effects of Market Crashes

Crashes can lead to a bear market. That's when the market falls 10% beyond a correction for a total decline of 20% or more. A stock market crash can also cause a recession.

Stocks are an important source of cash that corporations use to manage and grow their businesses. If stock prices fall dramatically, corporations have less ability to grow. Firms that don't produce will eventually lay off workers to stay solvent. As workers are laid off, they spend less. A drop in demand means less revenue. That means more layoffs. As the decline continues, the economy contracts, creating a recession. In the past, stock market crashes preceded the Great Depression, the 2001 recession, and the Great Recession of 2008.

What Not to Do in a Crash

During a crash, don't give in to the temptation to sell. It's like trying to catch a falling knife. A stock market crash will make the individual investor sell at rock-bottom prices. That's precisely the wrong thing to do. Why?

The stock market usually makes up the losses in the months following the crash. When the market turns up, sellers are afraid to buy again. As a result, they lock in their losses. If you sell during the crash, you will probably not buy in time to make up your losses.

Your best bet is to sell before the crash. 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. But most investors wind up buying right at the market peak. Emotion, not financials drive them. 

What's the solution? Keep a diversified portfolio of stocks, bonds, and commodities.

Protect Yourself by Rebalancing

Rebalance your portfolio as market conditions change. If you've done this well, then you've sold off stocks when they gained in value. If the economy does enter a recession, continued rebalancing means you will buy stocks when the prices are down. When they go up again, as they always do, you will profit from the upswing in stock prices.

Rebalancing a diversified portfolio is the best way to protect yourself from a crash. Even the most sophisticated investor finds it difficult to recognize a stock market crash until it is too late.

Gold Can Be a Hedge

Gold may be the best hedge against a potential stock market crash. A study done by researchers at Trinity College found that, for 15 days after a crash, gold prices increased dramatically. Frightened investors panicked, sold their stocks, and bought gold. After the initial 15 days, gold prices lose value against rebounding stock prices. Investors moved money back into stocks to take advantage of their lower prices. Those who held onto gold past the 15 days began losing money.

Most financial planners will tell you that the best hedge during turbulent times is not gold or any other single asset. Instead, you should have a diversified portfolio that meets your goals. Your asset allocation should support those goals.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.