A stock market crash is perhaps the most dreaded word in the stock market parlance.
There is a myriad of descriptions, from panic, fear, losses to the massive reallocation of resources.
What is particularly worrying is that stock market crashes never come alone.
Invariably they are accompanied by a period of severe economic turmoil.
You feel the stress across asset classes.
Investors are wary of investing if the stock market crashes.
It is almost like the market suddenly loses its magic wand.
You are wary about trying almost any asset.
They are all shrouded by an aura of mystique, fear and depression.
So what happens if the stock market crashes?
A typical dictionary definition refers to severe value erosion in the stock market.
Most times this severe cascading effect is very sudden, and the market does not get a chance to respond.
There is a severe spiraling down of valuation.
It can often be an outcome of any major economic event or geopolitical situation.
The core problem here is that the situation further exacerbates the economic crisis.
While it is the outcome of one problem, it also becomes the beginning of a new one.
Let’s understand what happens exactly to fully understand the impact of the stock market crash.
When the market cracks abruptly, fear rules the street.
But only a few of us have foresight like that of the Oracle of Omaha.
Almost involuntarily, this brings forth renewed selling spree.
As a result, there is a further devaluation of assets.
Investors become unsure and risk-averse.
This panic triggers widespread margin calls.
The liquidity in the market is pulled away.
Cash becomes the king, and everyone wants to exit stocks.
Yes, flight to safety becomes the buzzword during stock market crashes.
Panic & Stock Market Crash
If the stock market crashes, panic is often the first reactions.
Fear of deeper losses is what exacerbates the impact of the stock market.
In other words, investors are worried about what happens next.
A crash is never as per textbook predictions.
Most times it is completely sudden and takes investors by surprise.
Perhaps domino effect best explains the phenomenon that takes place.
Typically you will notice that the selling spree does not end in one session.
If you consider the most talked about stock market crash in 1929, there was a Black Friday.
But it was also followed by a Manic Monday and equally devastating Tuesday.
Well, this is because of the widespread panic that grips the street when the stock market crashes.
Normally when one investor starts selling stocks, others start buying at the discounted level.
But this does not happen in case of a crash.
There is nervousness all around the market.
One sells, the others join in too.
Just a few members selling their stocks can trigger a price correction.
A widespread collection of such groups results in a stock market crash.
The fear of what happens next leads investors to hunt for safety.
Often cash is the ultimate answer to this flight to safety.
As the downward spiral in prices continues, investors increasingly look for haven.
The paucity of cash or liquidity at this juncture heightens their fear even more.
As a result, there is even a greater degree of demand for cash.
This, in turn, further exacerbates the fear in the market.
Investors, therefore, try to retrieve whatever value they can from their investments.
It is this panic that then goes on to impact the rest of the market decisions.
The loss of logic and fear deepen losses further.
Economic Crisis & Stock Market Crashes
There is one thing certain about most stock market crashes.
Barring the smaller correction in prices, almost all big crashes are accompanied by a huge economic crisis.
Let’s start with some of the earliest records of the stock market crash.
The stock values declined almost 80% between 1929 and 1932.
Huge portfolios got eroded entirely.
Most people who had portfolios diversified did not escape from the fury either.
Almost overnight, liquidity left the bourses almost completely.
Lesser amount of cash resulted in even further redemption in the market.
Gradually every sector was dragged into the huge downward spiral.
This huge value erosion impacted the rest of the economy too.
This eventually led to the great depression in 1929.
Now if we analyze a more recent stock market crash, the same trend manifests.
The US housing market slumped, and this led to the stock market crash in 2008.
Almost like a domino effect, one by one every sector fell.
The Dow Jones cracked over 500 points in a single session.
One by one, every asset class started yielding to the market pressure.
Lehman became bankrupt; major corporates had to seek aid from the Government.
Production and economic growth slumped, and manufacturing almost came to a standstill.
Gradually this slowdown in US markets affected markets across the world.
All at once, the entire world was in the throes of a huge economic slowdown.
Central banks from across the world joined hands to pump in money world over.
Global economies gradually limped back to normalcy with the help of these coordinated quantitative easing.
Bit by bit, the demand scenario and the manufacturing sectors revived.
But the scars of the stock market crash continue to manifest in many quarters globally.
How Do Investors Lose in Stock Market Crash?
Stock market crashes and losses go hand in hand.
During the 1987 crash, the markets fell close to 20% in a single session.
The share prices also turn very volatile around a crash.
As a result, the smallest mistakes can wreak untold havoc for the investors.
If investors cannot quite gauge the extent of price fluctuation, it is best to avoid the trade for a period.
Depending on the type of sector you are invested in, losses can vary anywhere from 7-75%.
This dramatic drop in prices is what leads to far-reaching losses for them.
For example, let’s say you bought a share for $100.
Now prices drop sharply by 50%.
So your valuation drops to $50.
In case you sell the shares at this rate, your net loss is $50.
But on the contrary, if you don’t sell it and hold for long-term, it will always generate higher returns.
Buying on margin during a stock market crash can also deepen losses.
Often this is the single biggest reason for investors losing huge amounts.
In this case, investors borrow money to book profit over a specific period.
Most times investors look at mobilizing their personal resources to this end.
So apart from the money that is borrowed, they put their personal savings also at stake.
The idea is that once they sell their position, they can repay the loan and pocket the profit.
But if the stock market crashes, this entire equation changes.
Apart from the overall loss in the portfolio, there are additional liabilities.
During the Great Depression, many investors were leveraged to a large extent.
As a result, this exacerbated the financial crisis that followed soon after.
Many lending institutions and banks too suffered losses and bankruptcy as a result.
Stock Market Crash Affects Investor Conviction
When you ask what happens if the stock market crashes, the first casualty is investor conviction.
Whether you are looking at large corporates or small investors, it makes them all cautious.
No one wants to undertake unnecessary risk, and everyone wants to be careful.
The pain of losing money is multi-textured.
It is never just the concept of physical loss.
Often investors have to bear the long-term consequences of these monetary losses.
Apart from the mere concept of losing money, less amount of money impedes investor behavior.
It affects the ability to take up risk in the stock market to a large extent.
Corporates are unable to raise adequate funds through the share sale.
This, in turn, affects their business expansion and future strategy.
In short, the overall money supply declines as a result of this.
This note of caution then gradually percolates through the overall economy.
The problem of one company soon spreads to the entire economy.
Then the entire country slowly comes within the grip of this slowdown.
If you are towards the fag end of your professional career, this becomes even graver.
The stock market devaluation affects assets across the board.
So, it severely impacts the overall retirement funds as well.
This is because a bulk of these savings is deeply invested in stock markets.
So a retiree’s plans may completely collapse.
They may have allocated savings on the basis of a certain planning.
But the stock market crash completely puts the entire plan of action out of gear.
What is particularly disturbing is the lack of preparedness.
Even the best of market leaders cannot predict stock market crash with precision.
They can only make potential assumptions about fair price levels.
Loss of Confidence in Risk
The pain from stock market losses severely dents investor confidence.
When you analyze on a person to person basis, you will realize the how deep the wounds of stock market crash runs.
When investors see their portfolio smothered in losses, they only think about preserving capital.
The only response at that period is to take out as much money out of stock markets as possible.
Minimizing risk and maximizing returns seems to be the cardinal objective.
Perhaps that is the reason why often investors burnt by a stock market crash prefer low-risk low investment options.
In fact, there are many interesting studies on the investor reaction after a stock market crash.
Somehow, no investors ever consider that the maximum possible damage is already done.
The constant fear is what happens next?
In fact, you have several groups of investors who live in this constant fear that there may be another crash.
It is this fear that often leads people to opt for low margin or low-profit options.
They even choose significantly lesser time duration.
The basic logic is that they will go home with at least some semblance of gains.
The lack of confidence also stops investors from trying risky assets.
Whether you are looking at well-established investors or first-time traders, the apprehension can be equal.
The point is investors are constantly looking for confidence boosters.
Whether they are betting on the market as a whole or just looking at independent counters, the idea is to invest in potentially reliable plays.
The lack of confidence stops them from choosing any high-risk instrument.
Therefore overall returns suffer as a result of it.
Even the thought of more money or larger return can woo them.
People are often affected for life in terms of market investment over the longer term going forward.
The Value of Doing Nothing
When anyone asks what happens if the stock market crashes, what’s your response?
I am sure that you will reply saying that it is rather unfortunate and people end up losing a lot of money.
But the fact is all these valuations, and relative sense of worth is purely notional.
Will you believe me if I said that the impact of a stock market crash is almost nothing?
Well, are you stunned by that statement?
But over the longer-term, this is the hard truth in case of most assets across the board.
So unless you need the money you have invested in stock markets tomorrow, there is hardly any loss.
For example, let’s assume that your portfolio suffered deep losses in the 1987 crash.
But you have remained invested for the longer term.
So you did not tinker with your portfolio at all.
On almost every parameter, you will notice that the markets are significantly better off.
The Index to index return is higher, and so is the overall market valuation.
So if you chose to do nothing back then, you are undeniably benefitted positively today.
Your overall portfolio gains are significantly higher than any profit that you have suffered.
Perhaps this is much easier said than done.
When the news channels around you are screaming table after table of the net loss, the wound becomes deeper.
As someone said, you should do everything but do not evaluate the total account balance.
The need of the hour at that point of time is to take a deep breath and look the other way.
You have to stop paying heed to the general doom’s day call all around.
Remember, you are already neck-deep in the loss, how much worse can it be?
It can only improve henceforth!
Do Not Sell
Remember what Warren Buffett says about panic.
According to him, that’s the best period to buy in the market.
The general sense of gloom results in severe value erosion.
A sensible investor never fails to grab this opportunity.
This is the right time to scour for long-term value buys.
Remember a stock market crash and the period soon after is a tricky time.
Stock valuations are volatile, and you can easily get caught in the price swings.
Therefore, it is best to avoid any type of share sale.
Anyway, prices have hit rock bottom.
So it isn’t like you will derive great value from this sale.
You may think it is better to take cash and exit markets for now.
You may consider entering markets when the condition improves.
But the fact is that there is no such clear indicator when condition betters.
But when you stay invested for longer term and exit at will, you can take advantage of every peak.
You will not miss out on the bull rallies that inevitably follow a prolonged bear run in markets.
This is often the best time to buy or expand exposure in stocks and sectors.
So, What Happens If the Stock Market Crashes?
Losing hope is never the right approach when the stock market crashes.
As an investor, you should not be too worried about the broad impact of the stock market crash.
You have to focus on how you are impacted if the stock market crashes.
That alone will help you create far-reaching strategies if the stock market crashes.
You have to concentrate completely on how to maximize your gains.
Do not fall prey to the general sense of doom and gloom all around.
As astute investor is always on the lookout for gains even in the face of adversity.
So it is high time to stop worrying about what happens if the stock market crashes.
Just see how you can profit from the stock market crash.