How Does a Stock Market Crash Occur?

by Eric Dontigney, studioD

A stock market crash occurs when the value of stock shares, such as those traded on the New York Stock Exchange, undergo a rapid, catastrophic drop. The "how" of a stock market crash ties into economic activity, stock market speculation, investor psychology and even political events.

Economic Activity

The degree and type of economic activity impacts the stock market. If, for example, unemployment remains low and purchasing remains steady or increases, the stock market tends to remain steady or improve. An economic slowdown that only affects portions of the economy, such as the agricultural recession during the 1920s, can help to trigger a crash. However, while recessionary tendencies may precede a crash, they almost always follow a stock crash. Periods of ongoing inflation also serve as a trigger. As the purchasing power of money decreases, people buy more selectively. Business revenue drops, the economy slows and stock prices suffer.

Careless Speculation

All stock trading functions as speculation at one level or another. In some cases, however, the perceived value of the stocks or companies far outstrips any realistic assessment of the actual value. The soaring stock prices create a bubble, such as the dot-com bubble in the early 2000s or the housing bubble in 2005-2006. Eventually, the stock prices reach an unsustainable level and a market crash follows. The NASDAQ dropped approximately 80 percent in the dot-com crash and the Dow Jones Industrial Average dropped approximately 50 percent following the housing crash. Fortunes evaporate as stock prices plummet and on-paper capital vanishes out of the market, which restricts trading in other sectors.

Investor Psychology

Investor psychology contributes to the bubble-crash trend. During the bubble phase, investors display overconfidence about the potential of certain stocks. During the crash, investors experience a kind of pendulum swing from excessive optimism to excessive caution. The tendency toward excessive caution makes investors dump stocks to protect or preserve their assets, but can also lead them to sell off only moderately risky stocks. Other investors take note of the sharp drop in stock prices and also start to sell, which leads to the catastrophic drop in values that mark stock market crashes.

Precipitating Event

Stock market crashes usually begin with a precipitating event. A stock market bubble bursting might trigger a crash. A geopolitical crisis that creates the threat of war or military action has historically led to stock market drops. The Standard & Poor’s stock index dropped 11 percent in the lead-up to the 2003 invasion of Iraq. Any widespread crisis at a national or international level creates the potential for a stock market crash.

About the Author

Eric Dontigney received a Bachelor of Arts in philosophy with a psychology minor. He has been writing for more than 10 years and presently works full time as a writer. Most of his writing work is done for private clients.

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