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What Is a Stock Market Crash?

December 02, 2020 · 7 minute read

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What Is a Stock Market Crash?

A stock market crash is defined by double-digit declines that happen quickly across a broad stock market index or group of related indexes.

As the coronavirus pandemic swept the United States in February 2020, the government responded with stay-at-home orders that shut down businesses and curtailed travel across the country. The U.S. economy entered a recession, and the stock market plunged. The S&P 500, which tracks the largest 500 stocks by market capitalization, fell 30% into bear market territory in just 22 days—the quickest drop of that magnitude ever.

The stock market crash in the first half of 2020 is not without precedent. It’s one in a long line of crashes dating back to the Great Depression and beyond. Here’s a deeper look at what is considered a stock market crash, what happens when the stock market crashes, and what investors can do to prepare their portfolios.

What Happens When the Stock Market Crashes?

Market fluctuations are a natural part of the stock market’s cycle. Day to day and week to week, the market will experience a certain amount of volatility. And from time to time, the stock market will experience a downturn that sends it into correction territory.

A stock market correction is when the market falls 10% from its most recent peak. Corrections are often a sign that investors are becoming more pessimistic in their outlook on the market. They can be short-lived, lasting only a day, or they can last a month or more.

A stock market crash is usually more dramatic than a simple correction. Generally speaking, a crash is defined as a dip of more than 10% in a single day. They are typically sudden and can be sparked by a catastrophic event like a pandemic, economic turmoil, or the bursting of an economic bubble. The initial crash can set off waves of panic among investors, who may start dumping stocks, further depressing the market.

The market becomes a bear market when stocks drop by 20% or more from recent highs, which usually marks a period of sustained declines.

What Causes a Crash?

Stock market crashes are usually caused by investor dynamics—specifically investors’ collective fear, which can cause them to unload shares en masse.

One cause of stock market crashes can be the bursting of stock market bubbles. A bubble occurs when stock prices rise quickly, outstripping the value of the underlying companies. Bubbles can affect the market as whole, or specific sectors. The bubble forms as investors start to buy certain stocks, driving prices up. Other investors may see the stock doing well and jump on board, further raising prices and initiating a self-sustaining cycle of growth. The growth continues until something happens that makes investors wary of the stock. Then the bubble bursts and investors tend to unload shares as quickly as possible.

Catastrophic events such as natural disasters, pandemics, and wars can also trigger stock markets crashes, as can political and economic turmoil. For example, the Federal Reserve may raise or lower interest rates to address inflation or a slow economy. But raising the rates too high could lead to a sell-off.

A country struggling to pay its debts could set off a market crash as well. For example, in 2010-2011, Greece, Ireland, Italy, Spain, and Portugal were unable to grow their economies fast enough to pay back government bondholders, sparking the European Debt Crisis.

Other economic issues such as trade wars, a slowdown in economic growth, or systemic crises like the subprime mortgage crisis that triggered the 2008 banking crisis could also have a hand in a market crash.

Stock markets can also experience flash crashes, when a market plummets and rebounds within minutes. Computer algorithms can make these crashes worse by automatically reacting and selling stocks to head off losses. For example, on May 6, 2010, the Dow fell 1,000 points in 10 minutes but recovered 70% of its losses by the end of the day.

Trading on markets that experience flash crashes may be temporarily suspended to keep the crash from spreading.

What Are the Effects of a Crash?

Stock market crashes can lead to bear markets when the market falls by 20% or more. If the crash leads to an extended period of economic decline, the economy may enter a recession.

A market crash could lead to recession because companies rely heavily on stocks as a way to grow. Falling stock prices curtail a company’s ability to grow, and that can have all sorts of ramifications. Companies that aren’t able to earn as much may need may be forced to lay off workers. Workers without jobs aren’t able to spend as much. As consumers start spending less, corporate profits start to shrink. This pattern can lead to a cycle of overall economic contraction.

A recession is usually declared when U.S. gross domestic product, or GDP, shrinks for two quarters in a row. There may be other criteria for declaring a recession, such as a decline in economic activity that’s reflected in real incomes, employment, production, and sales.

Recommended: What Is a Double-Dip Recession?

Recessions are rare, but they, too, are a natural part of the economic cycle. Unfortunately, they can have lasting impacts. Businesses that don’t have enough financial resources to ride out the economic storm may need to close or file for bankruptcy. Retirement accounts that hold a lot of stocks, like 401(k)s and IRAs, can take a hit, which can be particularly hard on investors nearing retirement who need access to their savings. Housing prices also tend to fall during recessions, which can mean homeowners have less equity in their homes.

Historical Stock Market Crashes

There have been a number of stock market crashes in the past, the most recent being the crash associated with the coronavirus pandemic in early 2020. Four of the other largest crashes are the 1929 crash, the 1987 crash, the dotcom bust of 1999-2000, and the 2008 crash, which sparked the Great Recession.

Stock Market Crash of 1929

The period after World War I ushered in a time of U.S. prosperity that would come to be known as the Roaring Twenties. New investors poured money into the stock market, and many of them used borrowed money to make their investments. As stock prices rose and more investors were attracted to the market, a bubble began to form.

In October 1929, the bubble burst and the market unraveled. Panicked investors began to sell their stocks as quickly as they could, causing what would soon be one of the worst crashes in U.S. history and marking the beginning of the Great Depression.

Stock Market Crash of 1987

The 1980s began with the country in recession, but as the economy recovered, the market grew steadily throughout the middle of the decade, driven by low interest rates and growth in the computer industry.

By the late ‘80s, stock prices rose beyond their real value. The decade became known for highly leverage corporate takeovers and the use of questionable trading practices like leveraging junk bonds or margin accounts. At the same time, traders had widely adopted computerized trading platforms.

In October, the tides changed and investors began to sell. Computerized trading made it easier for panicked investors to offload stocks quickly, and stock markets around the world crashed.

Dotcom Crash

In the mid to late 1990s, the internet was widely available to consumers around the world. Investors turned their eyes to internet-based companies, leading to rampant speculation as they snapped up stocks of newly public (and unproven) dotcoms.

Eventually, startups that had been fueled by enthusiastic investors began to run out of money as they failed to turn a profit. At the peak of the bubble, large tech companies, including Dell and Cisco, placed sell orders, which sparked panic in the market. The bubble burst, the stock market plunged, and by the end of 2001, most publicly traded dotcoms had folded.

Great Recession of 2008

The stock market crash of 2008 was fueled by rising housing prices, which came on the heels of the recovery from the dotcom crash. At the time, banks were issuing more and more subprime mortgages, which financial institutions would bundle and sell as mortgage-backed securities.

As the Federal Reserve raised interest rates, homeowners, who often had been given mortgages they couldn’t afford, began to default on their loans. The defaults had a ripple effect throughout the economy. The value of mortgage-backed securities plummeted, causing major financial institutions to fail or approach the brink of failure.

Can Anything Prevent a Crash?

Stock markets have instituted circuit breaker measures to protect against crashes. These measures halt trading after markets drop a certain percentage to prevent the markets from going into freefall. Investors may have seen these them in action during market volatility in the early days of the coronavirus pandemic.

The New York Stock Exchange’s circuit breakers kick in when three different thresholds are met. A drop of 7% or 13% in the S&P 500 shuts down trading for 15 minutes when the drop occurs between 9 a.m. and 3:25 p.m. Eastern Time. A market decline of 20% at any time during the day will shut down trading for the rest of the day.

If a crash does occur and it threatens to weaken the economy, the federal government may step in to ease the situation through a combination of fiscal and monetary stimulus measures. Monetary stimulus is a set of tools the Federal Reserve can use to stimulate economic growth, such as lowering interest rates. Fiscal stimulus is generally infusions of cash through direct spending or tax policy.

Considerations During a Crash

A stock market crash can be a scary time. Investors who see stock prices take a dive may panic and want to sell. Panic selling, though, is likely not the right move to make during a crash because if investors sell as prices are falling, they may end up doing so at the bottom of the market. At the very least, selling locks in investor losses and forces them to miss out on subsequent market rebounds.

It’s unlikely investors will be able to time the market perfectly, selling high and buying low, so it may be better to avoid trying to do so. Consider that investors’ tendency to time the market, especially during downturns, is a major reason that equity fund investors underperformed the S&P 500 in the past 10 years. These investors earned a 9.4% annual return, while the S&P 500 earned 13.6%, according to a 2020 study by research firm DALBAR.

Investors who don’t need access to their money right away may be better off holding on to their investments for the long term, giving them time to recover.

Building a Portfolio to Weather a Crash

The stock market can be an uncertain place. But there are some things to keep in mind when building a portfolio that may help investors weather financial crashes.

Portfolios are commonly built with three important factors in mind: an investor’s goals, time horizon, and risk tolerance.

Investors’ goals are the things they’re saving for, such as a down payment on a house, a child’s college education, or retirement. These goals can help determine investors’ time horizon. For example, an investor may have 30 years before retirement. Generally speaking, the longer the time horizon, the more stocks a portfolio is likely to hold.

That’s because there is more time to ride out periods of volatility. If investors have less time before they need their money, they may hold more conservative investments, such as bonds that are less likely to be affected during periods of volatility.

Investors’ risk tolerance is how comfortable they are with volatility. This factor is related to time horizon—investors with long time horizons often have higher risk tolerance—but it’s also personal. Investors who know they won’t be able to sleep at night when markets are down may want to hold fewer stocks in their portfolio.

A portfolio that’s built with these factors in mind takes into account periods when the market is down. Investors can remind themselves of this fact if they become worried during a market crash, remembering that their focus is long-term goals, not short-term losses.

Visit SoFi Invest® if you’re ready to build your portfolio and start saving for your short- and long-term goals.

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