Stock Market Crash

DEFINITION of 'Stock Market Crash'

A stock market crash is a rapid and often unanticipated drop in stock prices. A stock market crash can be the result of major catastrophic events, economic crisis or the collapse of a long-term speculative bubble. However, public panic is a major contributor. Hordes of people removing their money from the banks or scrambling to sell their stocks and other assets all at the same time causes economic turmoil and exacerbates any existing economic instability.

BREAKING DOWN 'Stock Market Crash'

Although there is no specific threshold for stock market crashes, they are usually identified as abrupt double-digit percentage drops in a stock index over the course of a few days.

Well-known U.S. stock market crashes include the market crash of 1929, which resulted from economic decline and panic selling and sparked the Great Depression, and Black Monday (1987), which was also largely caused by mass panic. Another major crash occurred in 2008 in the housing and real estate market and resulted in what we now refer to as the Great Recession.

Preventing a Crash

Since the crashes of 1929 and 1987, measures have been put in place to prevent crashes due to panicked stockholders selling their assets in a fire sale. One method is to implement trading curbs, or circuit breakers, which prevent any trade activity whatsoever for a certain period of time following a sharp decline in stock prices, in hopes of stabilizing the market and preventing it from falling further. For example, the United States has a set of thresholds in place to guard against crashes. If the Dow Jones Industrial Average (DJIA) falls 2,400 points (threshold 2) before 1:00 p.m., the market will be frozen for an hour. If it falls below 3,600 points (threshold 3), the market closes for the day. Other countries have similar measures in place. The problem with this method today is that if one stock exchange closes, shares can often still be bought or sold in other exchanges, in which case the preventive measures can backfire.

Another way of stabilizing the market is for large entities to purchase massive quantities of stocks, essentially setting an example for individual traders and curbing panic selling. However, these methods are not only unproven, but may not be effective. In one famous example, the Panic of 1907, a 50% drop in stocks in New York set off a financial panic that threatened to bring down the financial system. J. P. Morgan, the famous financier and investor, convinced New York bankers to step in and use their personal and institutional capital to shore up markets.

Stock market crashes wipe out equity-investment values and are most harmful to those who rely on investment returns for retirement. Although the collapse of equity prices can occur over a day or a year, crashes are often followed by a recession or depression.

For a detailed lesson on market crashes and a history lesson on the most famous crashes from around the world, read The Greatest Market Crashes.

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