How Does a Stock Market Crash Occur?

Crash

By Gregory Hamel

  1. Economic Factors Spark Market Crashes

    • A stock market crash is a rapid fall in the prices of a large portion of the assets offered on a stock market. The overall performance of many stock markets is calculated using an average of some of their top equity assets, such as the Dow Jones industrial index, so a sudden decline in the level of these indexes is considered a stock market crash. One of the primary reasons stock markets crash is due to underlying economic factors, such as consumer confidence, inflation and gross domestic product. Consumer spending accounts for a large proportion of economic activity in the U.S., so when consumer spending declines for some reason, such as the burdensome costs of gasoline or health care, it leads to a slowing economy, or a recession. Recessions often cause companies to cut back on expenses, leading to layoffs, higher unemployment and even less consumer spending. This creates a chain reaction which leads to lower company profits, spurring investors to pull out of the market, which causes stock prices to plummet.

    Investor Psychology

    • Every economy is subject to normal business cycles-a series of economic busts and booms-but the normal business cycle is much less pronounced than a stock market crash. In a normal business cycle, the market is presumed to trend upward over time despite short-term setbacks. During the normal business cycle, investor psychology is mostly optimistic; when stocks are down investors see them as good deals, assuming they will rise in the future, which spurs investment and leads to higher stock prices. During a stock market crash, investor sentiment experiences a shift toward pessimism. Instead of buying up cheap stocks, inside investors pull out of the market in an attempt to guard against risk, causing market prices to fall. This causes other investors to panic and leads to huge numbers of investors pulling their money out of the market and a subsequent crash in prices.

    Speculation and Price Bubbles

    • Another important factor which can lead to the economic slowdowns and a shift in investor sentiment is speculation. Speculation in investing is the supposition that a certain investment will increase in value in the future. Speculators then purchase the asset which they believe will increase, in order to capture the gains when the asset price goes up. Whether or not the actual value of the underlying asset increases, the speculator’s purchasing of the asset increases its price, which can lead to more speculation and more investing further pushing up the price. Eventually this can lead to a price bubble, which is a greatly inflated price caused be the artificial demand introduced by the speculators. At some point the price of a highly speculated asset may reach a level so disjointed from what its true value should be, that investors begin to pull back and sell the asset. As soon as investors feel a certain asset’s price bubble is begging to burst, it can lead to a massive sell off which can adversely affect other parts of the economy, and spur a market crash.

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