As an investor, you must be afraid of losing money in the stock market. Many investors even ask questions like ‘Do you lose all your money if the stock market crashes?’ Undoubtedly, investing in the stock market is a risky venture but it can also be unusually dependable in the long run. The stock market is extremely unpredictable and it is quite common to lose money in stocks. However, what happens to your money if the stock market crashes?
If you are worried about losing money in the stock market crash, rest assured. Stock market crashes are quite rare and don’t happen often. And even if it crashes, it quickly rebounds in months. It has been nearly a century since the catastrophic stock market crash of 1929 that paved the way for The Great Depression. While the world hasn’t witnessed any crashes of such magnitude, there have been periods in which the stock price dropped massively.
So how do you know if the market is crashing? Do you lose all your money if the stock market crashes? In this blog, we will answer all these questions and also highlight how to navigate a stock market crash.
What is a Stock Market Crash?
In layman’s terms, a stock market crash is a dramatic, often unexpected, stock price drop in the stock market. There are many factors that can contribute to plummeting stock prices like economic conditions, catastrophic events, or speculative elements that sweep across the market.
There’s no specific number that indicates a stock market crash. For context, the S&P 500 stock index changes between -1% and 1% on any given day. Anything outside these parameters can be considered an active day on the market- for better or worse.
Suppose, the S&P 500 drops 6% in a single day, the trading will be halted for some minutes. It has only happened a few times in the market’s history and marks a very dark day on Wall Street. However, a drastic and sudden drop in stock prices is often followed by an uptrend, also known as a ‘bull market.’
What Happens When the Stock Market Crashes?
Do you lose all your money if the stock market crashes? Not necessarily, but it is more complex than that. When the market values of stocks decrease rapidly, we witness the basics of supply and demand in real-time. In simple terms, when there are more sellers than buyers of a particular stock, the stock price drops. When this phenomenon happens across a wide range of companies, the stock market goes down as a whole.
Stock market values can go down for a number of reasons. During the past two years, we have seen the market plummet due to the Covid-19 pandemic. However, if we take a look at the two-year pandemic as a whole, there has also been incredible growth in the market after navigating the choppy waters.
Stocks can trade in the short duration because of changes in expectations about the future. For instance, if the Federal Reserve Board announces it may raise interest rates more than the anticipated number, the market will react negatively. Tighter money policies can spook the market which leads to the selling of stocks. This frantic selling creates a positive feedback loop which leads to more selling.
What Happens to Your Money?
At the end of 2021, account values throughout the market were inflated. Share prices were at an all-time high for a number of months, which reassured the investors.
In January 2022, the Feds announced that they would increase interest rates faster than expected. This shook the S&P 500 and fell more than 10% from its all-time high of 4800. Although the index was only down 5.3% at the end of the month, it instilled fear in investors. With the S&P 500 falling quickly, investors felt as though large amounts of their money disappeared into thin air. And that’s exactly what happened.
Suppose you bought 100 shares of the fund when it was trading at $100 per share, spending a total of $10,000. If the market falls by 20%, the value of your shares will drop to $80, dropping your total investment to $8000.
When the market plummets or crashes, the total value of your investment also decreases. In simple terms, the market value of your shares has decreased, but you still own the 100 shares of the same company.
Keep in mind that investing in the stock market is a risky venture and the market values can fluctuate quite drastically. However, it is best to ignore short-term fluctuations and focus on a long-term approach.
How to Prepare for a Stock Market Crash?
First and foremost, it is best to have a long-term investment timeline and just ride out the waves until they subside. Understanding that a crash might happen means you can plan for it in advance and save your investments. Here’s a foolproof game plan for what to do during a stock market crash.
Know What You Own and Why
Getting startled and dumping all your investment because of a temporary slump might not be a very good idea. But you can find some good and reasonable reasons to sell if you refer to your original stock research notes.
Stock research notes include crucial information like a record of strengths, weaknesses, and the purpose of each investment in your portfolio. Your stock research notes are like an investing roadmap, which provides a tangible reminder of the things that make a stock worth holding.
During a market slump, this piece of document can help avoid throwing away perfectly good long-term investments just because it is performing poorly now. On the other hand, it also provides valid reasons to toss away a stock in case of poor performance.
It is crucial to know factors like your risk tolerance and how much volatility can you endure for higher potential returns. Investing in the stock market is a risky venture but long-term returns make up for it, which are always on the horizon for those who are patient enough.
Diversification is Essential
When a stock market crash happens, the stock prices will drop but the results may vary. Diversifying or distributing your investment across various asset classes is one of the key aspects of reducing investment risks and ensuring a smooth ride through choppy waters. It helps ensure that your investments are not concentrated in a single asset class. So, if a particular stock or industry is performing poorly, your other investments will make up for it.
If you are opting for a strategy like investing in retirement funds like 401(k) or robo-advisors, diversification is already built-in. If this is the case, it is best to just be patient, trust your portfolio, and weather the storm, You might experience some small shocks but there won’t be any significant losses that you can’t recover from.
Consider Buying the Dip
While most investors are particularly cautious of a stock market crash, it can also be a buying opportunity for you. Just think of it as buying stocks on a sale when the market is plummeting. The trick is simple- just be ready for the crash and commit some cash to buy investments whose prices are dropping.
However, this option is not for everyone. You should consider this option only if you have an existing emergency fund, allocated money for your retirement, and have extra cash lying around for daily expenses. In this case, you can use the extra cash to buy stocks in the flash sale on Judgment Day. Make sure to make a wishlist of individual stocks that you would like to buy.
If you do consider this option, chances are you won’t catch the stocks at their lowest, and that’s perfectly alright. The point of buying the dip is to be opportunistic on investments you think have long-term potential and are worth more than their current market price.
Also, it is perfectly fine to freeze during moments of opportunity. One of the best things to do is use the dollar-cost average strategy. It smooths out your purchase price and puts your money to work when other investors are heading for the exits.
A Quick Tip: If you are a long-term investor, a stock market crash simply means that the stocks and investments are on sale.
Get a Second Opinion
As mentioned above, being a long-term investor during a market slump can be rewarding if you time your investments properly. However, self-doubt and ill-advised strategies are quite common during tough times. Even the most experienced and confident investors can fall victim to poor choices and strategies stemming from short-term thinking. The key here is to not let self-doubt sabotage your financial goals.
If you are unsure about your strategies, consider hiring a financial advisor to provide a different perspective on your financial plan. In fact, it is quite common for financial advisors to have their own financial planners for the same reason. Moreover, you also get peace of mind as an added bonus since you always have someone to consult during tough times.
Focus on Long-term Strategies
When the market plummets, it can be frustrating to watch your investment’s value decrease and do nothing about it. It is quite common to feel pessimistic after a slump, but as a long-term investor, doing nothing is often the best course of action.
It is essential to remember that selling your investments during a market downturn means locking in your losses. For example, if you have invested $1000 in an exchange-traded fund that tracked the S&P 500 during the 2020 Covid market crash, that fund would have lost more than 30% of its value. If you would have panicked and sold your investment, you would have suffered a loss. However, if you held onto it, you would have recovered your losses by mid-2020.
Take Advantage When You Can
Watching your well-crafted portfolio plummet can be painful but making some smart decisions for your future can help reduce some of that pain. Most financial advisors also suggest that market slumps are good timing for Roth conversions. Investors can take stocks of the depreciated assets in traditional IRAs and transfer that money into Roth IRAs. Once the market is back to normal, those migrated assets can now grow tax-free.
However, it is important to understand your situation and financial conditions before Roth conversions. One major drawback is that they trigger additional taxes since the transfer creates more ordinary income. Make sure to consult a tax advisor to ensure that this move is beneficial for you.
Popular Stock Market Crashes in the U.S
Over the years, there have been several stock market crashes. Even though the market can get quite volatile, the truth is that stock market crashes aren’t that common. Here are some of the major stock market crashes in the U.S. for the past century-
The Great Depression Crash of 1929
This was the first major stock market crash in the USA where speculations caused stock prices to increase dramatically. The stock market plunged in response to an economic and investor panic, marking the beginning of the Great Depression. There was a growing interest in commodities like homes and autos which led to unsophisticated investors flooding the market, increasing the prices in a panic buying mode. The market eventually bottomed out in 1932, 80% below peak prices. It took nearly two decades for the stock market to fully recover.
The Black Monday Crash of 1987
The market plunged more than 25% due to investor panic, market decline, and haywire computerized trading. It became known as Black Monday. The market took nearly two years to recover and the Securities and Exchange Commission(SEC) implemented safety measures like trading curbs and circuit breakers to prevent panic selloffs.
The Dot-Com Crash of 2000-2001
Similar to the Black Monday Crash of 1987, the Dot Com crash was also triggered by technology stocks. The interest of investors in the technological sector increased to a frenzied level after the massive adoption and growth of the internet. Many tech-related start-ups and companies were able to raise millions of dollars by going public with only an idea. Many of the companies burnt through all of their capital and the S&P dropped nearly 50%. It took almost seven years for the market to recover completely.
The Stock Market Crash of 2007-2008
The market crash of 07-08 was triggered by the subprime mortgage crisis and the collapse of mortgage-backed securities in the housing industry. A high volume of speculative trading caused the securities to rise and fall in value as housing prices receded. With most homeowners unable to meet their debt obligations, financial institutions declared bankruptcy, triggering the Great Recession. Some investors also think that incessant hedge fund investing was also the reason behind this market crash.
The COVID Crash of 2020
The market collapse of February 2020 was attributed to the government’s reaction to the COVID-19 outbreak, a highly contagious coronavirus spreading all across the globe. The pandemic negatively impacted many industries including healthcare, food, technology, etc. The market fell over 30% in just over a month. However, quickly rebounded by the August of 2020, taking only six months to recover.
Even in 2023, the stock market continues to witness drastic fluctuations as investors establish rising interest rates to fight inflation. Although the S&P 500 has had fairly decent uptrends this year, it doesn’t mean that investors don’t feel stressed and anxious in this unsettling economy.
From bank collapse to concern over the rising interest rates, there have been many instances when the market fell into the red zone. It is only natural to wonder- Is the stock market crashing? However, it's not something you should worry about too much. As long as you have a diversified portfolio and focus on long-term investments, you can easily take advantage of the market slumps.
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Frequently Asked Questions(FAQs)
Ans. Not necessarily, as long as you are patient enough to weather out the storm and hold onto your investments, you can recover from your losses. If you panic and sell your investments during a market downturn, you lock in your losses. However, if you wait for the market to stabilize, you can save your investment and portfolio.
Ans. Unless you are in urgent need of money or there is fundamentally wrong with the financial planning of the company whose stock you own, you should not sell stocks in panic. It is better to wait and see if the stock prices reverse and recover when the market stabilizes. Avoid panic selling unless it's absolutely necessary.
Ans. When the overall market declines, the market value of the stock you own will decline as well. However, if you don’t sell and still own those shares, the value can rebound and recover when the market changes direction and moves up again. You may lose the value of your stocks but often it is temporary.