Causes Of A Stock Market Crash (1)

Key reasons for a stock market crash involve panic from speculation as well as a number of political and social environmental factors

Stock market crashes are brutal. You might not have been actively involved in any one, but there is no underestimating the effect and consequences that arise from it. A stock market crash refers to a drastic decline in stock market prices over a short period of time.

This typically happens in a significant part of the stock market. There are a myriad of complicated issues that could lead to crashes in the stock market. While they could get complicated, an understanding of them will help the reaction of the investor towards cutting losses or finding opportunities.

Key reasons for a stock market crash involve panic from speculation as well as a number of political and social environmental factors. Here’s a rundown of some of the causes of a stock market crash.

Speculation and Panic

Speculation is a major cause of stock market crashes across the world. In light of issues around specific industries, political environments and more, individual investors begin to make decisions – rational and irrational.

However, since the market thrives on the movement of demand and supply, the reaction from a good amount of people in the stock market is enough to cause an overall crash. This was the primary cause of the 2008 stock market crash.

Speculations in the real estate sector with issues with mortgages and the inability of banks to carry out due process. When investors panic, they make mass decisions that drive the overall market.

While there is only very little the investor can do to rise above the movement of the market, moving with the crowd does not lead to a better outcome.

Overvaluation Of The Stock Market

If the price of a commodity is N50 but as a result of its scarcity and the inability of supply to meet demand, an increase in price is forced. However, that price can only continue for too long. Things always return to the mean.

In the stock market, there are general indices or ratios that give a true and fair representation of the market. These indices like the price-to-earnings ratio will tell of the true valuation of the price of a stock or the value of the stock market in general.

Using just the PE ratio, you can determine the price investors are willing to pay for N1 of a company’s profit. Where the ratio has a less value than the stock market (in other words, undervalued), it means that the stock still has a world of potential to grow into.

Meaning your money grows. However, where it is higher than its true worth, it has no other option than to crash as market tactics cannot sustainably hold. The issue is that the stock market can generally stay overvalued for a long time before correcting itself.

Unfortunately, without taking a look at stock fundamentals, investors might be unaware that they are trading on unstable figures until an imminent crash.

Yet, these are only two reasons an entire stock market could crash. In our next post, we will review some other causes for a stock market crash particularly in relation to external catalysts like the unstable economic and social terrain we are faced with today.

Written by Lawretta Egba.