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What Causes a Stock Market Crash? Five Popular Theories

Money can’t buy happiness, but financial stability can be a key factor leading to happiness in our modern society.

Financial stability and literacy help us to feel like we’re in control and living a life of certainty. When our finances seem uncertain, we likely feel stress.

But, imagine this type of uncertainty on a national or global scale. That’s exactly what happened in 1929 when the stock market crashed. It also happened again in 1987 and 2008.

So, what causes a stock market crash?

Normally, there isn’t one clear cut answer.

Stock market crashes are usually caused by a combination of factors that interact together. And, as we know from the Great Depression, a stock market crash can have dire consequences on families and the economy such as unemployment and lower wages.

What are these factors that could lead to a stock market crash? Read on to discover five popular theories that experts think lead to a stock market crash.

Expert Theories: What Causes a Stock Market Crash?

Stock market crashes can be devastating for many. The market rises and falls and we’re left to analyze why. Here are 5 popular theories and factors that address why the stock market crashes.

1. Overconfidence

When the economy is strong, people purchase items, stocks, and goods with confidence. When they see the stock market is doing well, they also are more likely to take bigger risks. Their rationale usually goes something like this, “The market is going up, up, up! Go big or go home.”

They invest because of the thrill of making more money and getting a return on their investment.

At this point, people are more likely to borrow money accumulating debt on bank credit and then invest their money into the market. This practice is known as purchasing stocks on margin.

In the 1920s, this type of investing was abundant.

People borrowed money from their stockbroker only paying a portion of the sum they invested. On the surface, purchasing stocks on margin makes the stock market look healthy and strong.

But, when the 1929 stock market crash happened people frantically sold their shares or lost all the money they invested. Banks, investors, and stockbrokers alike all suffered causing a huge loss of confidence on Wall Street.

2. Panic

Wide-scale panic causes people to make rash decisions.

Wide-scale panic and speculation can begin with a public figure’s comments, news articles, or drop in the market. Fears about a certain industry, asset, or financial change are usually panic-inducing factors as well.

This causes an extreme lack of confidence and a surge to get out before it’s too late.

When these factors occur, the average person usually follows the crowd and what the mainstream media is reporting. In terms of stock market crashes or the fear of a stock market crash, they withdraw their investments and sell their shares.

This makes a bad situation even worse and causes a larger loss in the market sometimes leading to a crash.

To learn more about investing and financial security it’s best to consult with a financial advisor or a highly trusted source than to rely on individual media coverage.

3. Rising Interest Rates and Inflation

When interests rates rise, people are less likely to purchase investments and stocks. Rising interest rates mean higher borrowing costs which turn people off to purchasing large investments like a home.

When this occurs, stocks related to the interest rate spike suffer.

Inflation also can be a factor leading to a stock market crash. Inflation occurs when the costs of goods rise despite the product being the same.

Inflation is measured through the consumer price index which calculates the average cost of goods and services.

Inflation rates and interests rates affect what’s called the present value of any sum of money. These rates can either make investing in stock a good idea or not depending on what the lump sum will be worth in the future.

Some experts believe it’s not inflation itself that causes stock prices to drop, but actually what’s called “inflation illusion.” This is what happens when investors focus solely on the inflation rate and present value.

The positive side of inflation is that if companies can raise their prices it means that their products are also in higher demand.

When they sell goods for more, they make more money. However, people with “inflation illusion” usually don’t consider this aspect of inflation which lowers the value of stocks.

4. Political Turmoil

When politics are uncertain, the market can also be uncertain. Political turmoil such as wars and scandals can negatively affect investors which lowers confidence and growth in the market.

For example, if the U.S. declared war on another country, U.S. citizens would likely be more concerned with how they were going to financially survive now rather than how much they could make in the future.

This may cause them to sell their stocks and shares because of uncertainty.

5. Industry Crisis

When people believe an industry is in crisis, it loses confidence in that industry and in its stocks. In short, no one wants to invest their money into a failing business.

But, many industries are needed for our economy and society to operate successfully. For example, real estate, agricultural, and automobile. These industries can be responsible as well for a healthy economy.

In short, when industries do well, the economy usually does well, too. When industries are failing, people are more likely to lose their jobs and lose money on their investments.

This causes a lack of confidence in that industry which can then lead to less investor certainty.

What Causes a Stock Market Crash? Not One Clear Culprit

Economists can try to pinpoint what causes a stock market crash, but usually, a combination of multiple factors is to blame.

Many other factors can also lead to a stock market crash, but for a market to crash many factors simultaneously interacting are usually the cause. Finding the potential causes may also require looking at stock market trends and the economy during years prior as well.

Some financial gurus look at the market dropping as a positive.

They advise investing when prices are low and when most people want to back out.

But, as we’ve seen from major stock market crashes throughout history, many people are concerned with securing their future in the present than taking a risk of earning more money in the future.

To get the soundest advice, it’s recommended to speak with a highly trusted financial advisor or source.

Want to learn what stocks were the best and worst in 2018? Check out our blog post to discover more.

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