How Does a Stock Market Crash?
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Economic Performance
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A stock market crash is characterized by an extremely rapid sell off of assets in a stock market, which results in quickly falling stock prices. While there is not one cause to any stock market crash--and different crashes are likely to be caused by completely different circumstances--underlying economic performance is a key factor which weighs heavily on investor sentiment. If the economy is growing and gross domestic product is rising, investors will tend to be more optimistic. That will make market crashes less likely.
If the economy suddenly slows down--or grows at an amount significantly less than forecasts--it might cause investors to sell stocks. The selling of stocks could create the beginnings of a crash. High real interest rates, inflation and unemployment can also affect the level of the stock market.
Investor Mob Mentality
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While overall economic performance may be the most important indicator as to the direction of the stock market, a crash can be caused by any event which leads to a mass sell offs of stocks, be it economic or not. For instance, in the days following the 911 attacks in New York, the stock market fell sharply due to widespread uncertainty and panic as to how the event would eventually affect the economy. This presents a valuable insight into the way stock market crashes occur: almost always, a crash is the result of an investor mob mentality of panic and a negative outlook about the future. When a few top level investors pull out of the market due to a certain event, others are likely follow suit, creating a rush to sell off stocks before prices fall even farther as the news spreads. This sort of behavior is common toward single stocks in normal business cycles. However, during a market crash, such behavior becomes widespread across entire sectors of the economy.
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Overvalued Assets
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Another factor which can create an environment prone to stock market crashes is the tendency for certain assets to become overvalued due to price speculation. When investors assume a certain asset will gain value in the future, they will buy up that asset in an attempt to reap the benefits of those gains. When many investors buy the same asset with the expectation of future gains, the demand they create raises the price of the asset. Essentially, the investors create a self-fulfilling prophecy. If more investors continue to demand the asset due to its strong performance, it can continue to inflate the price of the asset beyond what the actual value of the underlying asset may be. At some point, the price of the asset will reach a level where it becomes clear that the price is disjointed from real value of the asset, sparking an investor sell off and a rapid decline in price. A sell off could cause a panic leading to the sale of other assets. For instance, in the economic downturn of 2008, real estate and oil developed price bubbles; those bubbles collapsed quickly. That impacted many other sectors of the economy and contributed to falling stock prices.
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