You know the risks of putting your money in the stock market. While the potential for strong returns over the long run is appealing, the volatility can be unsettling. Stock market crashes seem to come out of nowhere, eliminating years of gains in days or weeks. However, by understanding the causes of crashes and implementing prudent strategies, you can protect your investments even in the worst times.
We will explore some triggers that can lead to stock market crashes and provide recommendations for defensive investment approaches.
While there are no guarantees in the stock market, preparation and knowledge can help protect your hard-earned money from catastrophic losses.
Staying invested for the long term is key, as is managing risk.
Read on to find out how.
Defining Stock Market Crash
A stock market crash is a sudden, major drop in stock prices across a significant cross-section of a stock market. Stock market crashes are often associated with speculation and investor panic. They tend to cause a temporary disruption in the functioning of financial markets and a loss of wealth.
There are several reasons why stock market crashes occur:
- Speculation – When stock prices become overinflated due to excessive speculation by investors, the market becomes unstable. Eventually, the bubble collapses, and stock prices come crashing down.
- Investor panic – Many investors panic and sell their stocks to avoid further losses once stock prices decline rapidly. This mass selling further drives stock prices down, fueling a crash.
- Economic crisis – A major economic crisis, such as a financial crisis or recession, can weaken investor confidence and cause a stock market crash as share prices plummet.
- Geopolitical events – Major geopolitical events like wars, terrorist attacks, or political instability can spook investors and trigger a stock market crash.
Most Notable Crashes Throughout History
The stock market has experienced several major crashes that have severely impacted the economy. Two of the most significant crashes in the U.S. stock market include:
The Wall Street Crash of 1929
Also known as the Stock Market Crash of 1929 or the Great Crash, it began in October 1929 and was the most devastating stock market crash in the history of the United States. It marked the beginning of the Great Depression, which lasted about a decade and affected all Western industrialized countries.
The Stock Market Crash of 1987 (Black Monday)
On October 19, 1987, stockbrokers in New York, London, Hong Kong, Berlin, Tokyo, and just about any other city with an exchange stared at their screens in disbelief as the numbers dropped sharply. It was the largest one-day percentage decline in stock prices in history.
Common Causes of Market Crashes
Stock market crashes often result from a combination of factors that create the perfect storm to send the market into a downward spiral. Two of the most common causes of major market crashes are overvaluation and weak economic fundamentals.
The market is considered overvalued when stock prices rise to levels not supported by the underlying fundamentals. As a result of the excitement and buzz surrounding new industries or technologies, investors drive up stock prices to unsustainable levels. Eventually, reality sets in, and investors realize their stocks are not worth what they paid. They start selling, which triggers a crash as stock prices drop significantly.
The dot-com bubble of the late 1990s best illustrates a crash due to overvaluation. Investors invested money in internet startups with little regard for traditional metrics like profits or revenue. The bubble burst once investors realized many of these companies would never profit. The NASDAQ fell over 70% from its peak in 2000 to its low in 2002.
Weak Economic Fundamentals
A weak economy with declining growth, high unemployment, rising living costs, increasing consumer debt levels, and falling corporate profits can weaken the stock market. When economic activity slows, consumer and business spending also declines. This leads to falling corporate revenues and profits, making stocks less attractive and valuable to investors.
The stock market crash of 1929 that kicked off the Great Depression was precipitated by a weakening economy and declining corporate profits after a decade of strong growth in the “Roaring Twenties.” In the months leading up to the crash, signs were apparent that the economy was slowing, but widespread speculation in the stock market overshadowed the warning signs. By the time the severity of the economic decline was realized, the stock market had already been decimated.
Strategies to Protect Your Investments During a Crash
To protect your investments during a stock market crash, you can employ several prudent strategies.
Diversify Your Portfolio
A diversified portfolio with a variety of asset classes can help reduce risk. Don’t put all your eggs in one basket. Allocate your investments across different asset classes (stocks, ETFs, etc.) and sectors. If one sector suffers losses, other sectors may hold steady or gain value. Diversification helps ensure that not all your investments will crash at once.
Maintain an Emergency Fund
Keep enough cash in an emergency fund to cover essential expenses for 3 to 6 months. That way, you won’t have to sell investments at a loss to pay bills. An emergency fund allows you to reverse market downturns until your portfolio recovers.
Focus on the Long Term
Don’t panic and sell in a crash. The market will likely rebound over the long run. If you sell at the bottom, you lock in your losses. It’s best to stay invested long-term and avoid emotional reactions. Historically, the stock market has always recovered losses and reached new highs. Have faith in the resiliency of the market.
Consult a Financial Advisor
If you’re unsure of the best moves to make during volatile times, consider consulting a financial advisor. An advisor can give guidance customized to your unique financial situation and risk tolerance. They have the experience to help you navigate uncertain markets and work toward your long-term investment goals.
These protective strategies can help safeguard your investments, even when the stock market crashes. With prudent planning and an eye on the long view, you can come out the other side, still progressing toward your financial objectives.
Recovering From a Stock Market Crash
Recovering from a stock market crash can be difficult, but taking prudent steps can protect your investments and even help you find opportunities.
Look for Buying Opportunities
Market crashes can create buying opportunities for long-term investors. Blue-chip stocks with solid fundamentals are often oversold during a crash, lowering their share prices. This allows you to buy stocks at a discount and benefit more when the market recovers. However, only invest money that you can afford to keep invested for at least five years.
Shift to Defensive Stocks
Consider shifting some of your holdings to more stable, defensive stocks like utilities, healthcare, and consumer staples. These sectors tend to hold up better during market downturns. Their stable earnings and dividends can help balance your portfolio. Once the market starts recovering, you can shift back to growth stocks.
Review and Rebalance Your Portfolio
A crash is a good time to review your investment portfolio and rebalance as needed. Make sure your asset allocation still matches your financial goals and risk tolerance. You may need to shift more to less volatile securities to reduce risk. Look for any weak areas in your portfolio and consider strengthening them. Rebalancing during a downturn can position you for better returns when the market recovers.
Following these steps may not prevent short-term losses but can help safeguard your investments over the long run. Staying disciplined during turbulent times is key to successful investing. Consult a financial advisor to help guide your decisions and keep you on track if needed.
While stock market crashes are inevitable and often unpredictable, there are prudent steps you can take to help protect your investments. Diversifying your portfolio across asset classes, industry sectors, and geographic regions can help reduce risk. Maintaining an emergency fund with cash on hand allows you to avoid selling at a loss during downturns. Reviewing your investment allocations and rebalancing periodically will ensure your portfolio aligns with your financial goals.
Market crashes can be unsettling, but staying invested for the long term and avoiding reactionary moves has historically generated better returns. The stock market has always recovered and gone on to new highs. With prudent planning and patience, you can successfully navigate the ups and downs of the market and work towards achieving your investment objectives.
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