How a stock market crash occurs can be answered fairly simply. Due to many factors, it’s down to a lack of confidence in the marketplace. We need to look at those factors to discover the answer to “how does a stock market crash?” If you would like, take a look at this previous post on the Stock Market Timeline.
If confidence in the market is lacking, it is important to consider both why and how. Does a stock market crash just on the say-so of a couple of people? Very rarely, but if those people are major investors who suddenly come out with adverse media comments, they could spark a crash.
Those comments may result from poor economic forecasts or lower than expected results for a particular sector. It doesn’t matter what causes the initial selling, and it’s how the more significant investors react that drives the market. Once ordinary investors see the major players leaving the stocks and shares of bigger companies, they get drawn into the “herd instinct.” That means that even though they don’t know for sure that something is wrong, they believe that others know something they don’t and begin to react without thinking for themselves.
For example, if the institutional investors feel one sector of the market is overpriced, they may decide to take their profits and run. That alone could cause small investors to try to get out while leaving fewer and fewer people who want to hold the stock resulting in panic. Here is a list of the largest single-day drops in the markets, Stock Market Losses.
Since the introduction of computers in stock market dealing, this blind panic reaction can easily spark a crash in the market. Because the computers are programmed to react to price falls of a certain percentage, they will indicate to the traders that they too should sell. What happens then? Other computers and traders get signals that the market for the shares has fallen and triggers their selling, and so the frenzy grows with each set of selling signals feeding the next round of price falls.
The major stock markets are so concerned about this automated selling cycle that they have measures to close the markets if prices fall below a certain amount within a particular time frame.
The markets also do not like uncertainty, such as the war in Ukraine combined with the Fed reacting to inflation and were behind on their actions to control it. And as inflation continues to climb, the Fed will likely react by raising interest rates which the markets also do not like, and this action generally causes prices to drop and fluctuate. So combine these factors, and you have the wild swings were are now experiencing daily.
But as Warren Buffett is famous for stating, “Be fearful when others are greedy, and be greedy when others are fearful.” This means you need to remember that when the markets are down, it is NEVER a time to sell and could present tremendous buying opportunities. Losses are not real until you sell. Otherwise, they are just on paper.
You can see that lack of confidence for either real or imagined reasons can answer the question of how does a stock market crash occur? For more information and how to gain some assistance in the markets, feel free to contact me directly if you are in or near the Metro-Nashville area. If you are outside middle Tennessee, contact a fee-only Registered Financial Consultant (RFC) near you.
