Unlike a typical bear market, which represents a gradual decline in the value and price of securities, a stock market crash is a sudden and very sharp drop in the value of financial assets. 2 After a crash, stock prices can take months or years to recover their value. For most investors, a crash is a painful ordeal and trying to figure out how to invest during a crash is typically a process fraught with emotion.
The better we understand what defines a stock market crash and learn the lessons from history, the better we can mitigate our losses and adopt a set of best practices to weather the storm of a crash when one does occur.
In this article:
What is a stock market crash?
A stock market crash is defined not only by an important decline in the percentage value of securities but also by the dramatic speed of the decline. Market crashes have occurred since the beginning of organized financial markets, and the history of those collapses continues to offer us lessons for the future. In 1929, the stock market lost 48% of its value in less than two months, while the Black Monday crash in October 1987 saw the value of stocks drop by almost 22% in a single day. 2
More often than not, a crash is a consequence “of a major catastrophic event, economic crisis, or the collapse of a long-term speculative bubble.” 3 As it spreads from sector to sector and region to region, the effect of a failure in one part of the economy can have a ripple effect across the national economy and, in many instances, the global economy as a whole.
What happens when the stock market crashes?
The stock market plays an essential part in a country's economy since it is made up of companies in a multitude of sectors that drive factors like employment, growth, output, and more. Less money flowing through the markets means less money to pay for jobs, factories and the array of goods and services that help grow the economy.
While a bull market positively affects economic growth, a bear market, or worse, a market crash, can cause a significant economic contraction and a recession.
Are market crash and recession linked?
It is common to hear about a stock market crash and a recession in the same sentence because a decline in the value of financial markets has important spillover effects for the larger economy. A recession refers to a large-scale economic decline and by definition "is a significant, widespread, and prolonged downturn in economic activity often linked to a country's gross domestic product (GDP)." 4
Biggest stock market crashes in history
Here are some of the biggest stock market crashes in recent history and what caused them:
-
Stock Market Crash - 1929: The stock market crash of 1929
followed a bull market that saw the Dow Jones Industrial Average
(DJIA) rise significantly over the previous five years. The
financial boom was a consequence of the growth of innovative
technologies like automobiles and telephones, alongside a new
industry of brokerage houses and investment trusts that made it easy
for people to invest using borrowed money.
5
Sensing that the speculative bubble was about to burst, the U.S. Federal Reserve Bank decided to raise interest rates and call in loans to curb speculation. This decision resulted in panic selling. On October 28, 1929, the DJIA fell close to 13% and continued to drop. By 1932 it had sunk to a level that was only at 10% of earlier peaks. 5 With the subsequent depression and the start of WWII, the DJIA did not return to pre-crash levels until November 1954. 5 - Black Monday - 1987: On Monday October 19, 1987, the DJIA lost almost 22% in a single day. The event marked the beginning of a global stock market meltdown and became one of the most notorious days in financial history. By the end of the month, most of the major stock exchanges around worldwide had lost more than 20% of their value. 6 Economists have attributed the crash to a combination of geopolitical events and the advent of computerized program trading that accelerated the sell-off. The crash lasted more than two years. Nevertheless, the recovery was quick. By 1989, U.S. stocks surpassed their pre-crash highs. 6
-
Great Recession - 2008: The economic downturn of 2007-2009
was a symptom of a financial contagion that began with a burst U.S.
housing bubble. During the American housing boom of the mid-2000s,
financial institutions were marketing mortgage-backed securities and
other complex financial products at an unprecedented level. The 2007
real estate market collapse caused a sharp drop in the value of
these securities.
Unable to cover their losses, over-leveraged banks and financial institutions started to go bankrupt. This resulted in the largest downturn in the U.S. economy since the Depression of 1929. By 2009 what had occurred in the U.S. became the tipping point for a worldwide financial crisis.xi The financial markets eventually recovered within 3.5 years, rebounding to pre-recession peaks by the middle of 2011. 7 - COVID-19 - 2020: The 2020 coronavirus stock market crash occurred due to panic selling following the onset of the COVID-19 pandemic. From February 12, 2020, to March 23, 2020, the DJIA lost 37% of its value, with some exchanges suspending trading to avert further losses. Recovery was quick. In November 2020, the DJIA reached a new historic high, hitting 30,000 for the first time in its history. 8
How long can a stock market crash last?
Since the Stock Market Crash of 1929 and the accompanying Great Depression, history has shown us that global financial markets inevitably do recover from a severe market downturn. Market crashes are shorter, and the rebound or correction to pre-crash levels happens relatively quickly.
Between the end of WW2 and 2020, there have been 26 market corrections with an average decline of 13.7% that have taken, on average, four months to return to pre-crash levels. 9 Nevertheless, short-term losses can be significant, and as history shows, some bear markets can take much longer to recover.
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Why do stock markets crash?
Even though the specific factors of a market crash can be very complex, economists and financial experts identify four underlying causes that can operate both individually and often together to generate a market crash.
- Panic: This is one of the most common factors contributing to a crash. 1 Stockholders are afraid that their investments are in danger of losing value and sell their shares to protect their money. As prices drop, the sell-off continues, and the fear spreads across different sectors of the economy, leading to a market crash.
- Natural or man-made disasters: These can include natural catastrophes such as floods, earthquakes or pandemics, as well as acts of war and terrorism. Disasters increase real or imagined risk and undermine investor confidence, slowing market growth.
- Economic crises: A problem in one industry or sector can have a ripple effect that reverberates and affects the overall economy. This happened during the 2008 Great Recession. The underlying problems with sub-prime mortgage lending created a domino effect across different sectors of the economy that then spread through financial markets triggering a global recession.
- Speculation: Financial speculation can create an unsustainable bubble when individuals and companies invest in a sector hoping that an asset or security will grow based on future performance expectations. If the hype and buying mania no longer deliver the expected financial results, the bubble bursts, and a mass sell-off occurs, leading to panic that spreads to other sectors across the market.
What can investors do to prepare for a stock market crash?
The possibility of a crash and an extended bear market is an inherent risk of investing and part of the natural cycle of financial markets. What can investors do to limit those risks?
- Do your research. Know what securities you own and why you own them.
- Determine the level of risk you are willing to live with. Use an investment strategy that is aligned with your risk profile. The use of stop loss orders can be applied on certain securities to manage the downside risk.
- Diversify your portfolio of assets. 'Not putting all your eggs in one basket' is an important principle, and diversification offers a critical strategy to shield your investments from a severe downturn.
- Exchange-traded funds (ETFs) are typically a basket of different securities that may include stocks, commodities or bonds that trade on the market like an individual stock. 10 ETFs can be a way to distribute investment risk.
- Invest systematically. Systematic investing involves investing a consistent sum of money regularly into the financial market when the market is up or down, and usually into the same security. By doing so, investors can benefit from dollar-cost averaging (DCA), lowering the long-term average cost of the asset. 11
- Focus on the long-term. History shows that markets will recover their value, but you must be prepared to weather the storm.
What should I do during a stock market crash?
Don’t panic. Remember that the stock market is a cycle and will eventually go back up again.
- Market downturns can be considered buying opportunities. Since you can't time the market, always be ready to 'buy the dip'.
- Try to avoid panic selling. Remember that losses are only
registered once you sell your securities. If you're losing sleep
over the markets, you might consider changing your investment
strategy or using tax strategies to offset your losses.
Tax loss selling is a tax strategy that investors can use to apply the value of the losses they've incurred. The losses are used to offset the capital gains taxes they might have to pay on any increase in the value of their securities. - If you are a long-term investor: Do nothing and stay the course. History has shown us that markets will eventually stabilize and regain momentum.
- For investors with a higher risk tolerance and the financial ability they can invest on margin to seize opportunities. But beware of the significant risks that are involved.
Investing during a stock market crash can feel risky, generate moments of panic, uncertainty, and portfolio losses. But in the long run, the stock market will eventually bounce back and recover.
Market downturns can be an important time to take a moment to pause and critically evaluate what you are investing in and why you are investing. Diversifying your portfolio can help reduce the risks, providing a healthy mix of assets that grow during good times and offer security during lean times.
One thing we can rely upon is that market crashes, bear markets, and downturns are part of the natural cycle of financial markets. Long-term investing with long-term investment goals typically provides the safest strategy and approach.
Find out more about how financial markets work. See our Analyzing the economy and stocks page.
