Stock market crashes have far-reaching consequences that ripple through the economy, impacting both individual investors and society as a whole. As stock prices plunge, the value of investors’ portfolios evaporates, retirement funds shrink, and firms with publicly traded shares find it increasingly difficult to raise the capital needed for expansion or operations.
For a new investor, the term “stock market crash” can induce panic. However, for seasoned veterans, these downturns are viewed as a natural, albeit painful, part of the economic cycle. India and the global markets have witnessed and experienced numerous stock market crashes in the past, where the severity, duration, and underlying causes of each crash have been vastly different.
Understanding the anatomy of a crash is the first step toward navigating one. From the Great Depression to the 2008 Financial Crisis and the recent COVID-19 pandemic induced market fall, history offers valuable lessons.
In this comprehensive guide, we will delve deep into what constitutes a stock market crash, the historical precedents, the nine major causes behind these financial downturns, and, most importantly, actionable strategies on what you can do when the bears take over the market.
A History of Turbulence: Major Stock Market Crashes
To understand the future, we must look at the past. Financial history is dotted with instances where market sentiment turned from euphoria to despair in a matter of days.
The Great Depression (1929)
The benchmark for all financial disasters remains the 1929 US stock market crash. Known as the Great Depression, this was not a fleeting event; it lasted ten years and stands as the biggest economic downturn in American history. Following the “Roaring Twenties,” a period of excessive speculation, the bubble burst on “Black Tuesday.” By the time the markets bottomed out, equities had lost over 90% of their value. It fundamentally changed how global economies were managed and led to the establishment of strict market regulations.
The 2008 Global Financial Crisis
The Financial Crisis of 2007-08 was another massive jolt to global economies, often cited as the worst economic disaster since the Great Depression. It was a result of the collapse of the US housing market—specifically the subprime mortgage bubble. Major financial institutions like Lehman Brothers collapsed, freezing global credit markets. The S&P 500 index dropped 51.9% in value. The ripple effect was immediate in India, where the Sensex also fell by around 52%, wiping out significant investor wealth.
The Harshad Mehta Scam (1992)
In the Indian context, the 1992 crash is perhaps the most infamous. Orchestrated by stockbroker Harshad Mehta, this event was driven by a manipulation of banking receipts and massive speculation. When the scam was exposed, it caused a massive crash in the stock market, and the BSE Sensex dropped by 12.77%. This event was a turning point for Indian capital markets, leading to the strengthening of the Securities and Exchange Board of India (SEBI).
The 2004 Election Crash
Political uncertainty is a major driver of market volatility. On May 17, 2004, witnessed what was then the largest point-wise fall in history. When the UPA government came to power with the support of Left parties, the market feared a halt in economic reforms. The BSE plunged 15.52% in a single day, triggering a halt in trading twice. However, this crash was short-lived as the new government assured investors of continued liberalization.
The COVID-19 Crash (2020)
Most recently, the 2020 Coronavirus stock market crisis showed how external shocks impact markets. Unlike the slow grind of 1929, this crash was rapid and violent. As nations went into lockdown, economic activity ceased. However, this crash only lasted a few months. Central banks flooded the system with liquidity, leading to one of the fastest recoveries in history.
What is a Stock Market Crash?
Stock market crashes have left a major impact on the way investors operate today, as well as on the security and regulatory measures that have developed over time. But how do we define it?
Different people have different meanings for a share market collapse. In technical terms, there is a distinction between a correction, a bear market, and a crash.
Market Correction: This is generally defined as a drop of 10% to 20% from a recent high. Corrections are considered healthy as they remove excessive valuation froth.
Bear Market: This occurs when the market drops by 20% or more over a sustained period (usually two months or more).
Stock Market Crash: Mostly, people believe that when a stock market index loses more than 10% of its value in a single day or drops very sharply over a few days, it is a crash.
A stock market crash, in a nutshell, is a dramatic fall in overall value driven by panic selling. But what triggers this significant downturn? Let us have a detailed look at the 9 major factors that lead to a stock market crash.
What Are the Reasons for a Stock Market Crash?
While every crash has a unique trigger, the underlying economic principles often remain the same. Here are the 9 major reasons for a stock market crash:
1. Economic Conditions and Slowdowns
The stock market is often considered a barometer of the country’s economy. Factors like inflation, growth prospects (GDP), interest rates, unemployment, and exchange rates fundamentally affect the economy.
If the economy is not doing well—indicated by slowing GDP growth—there will be less scope for corporate expansion. This reduces the profitability of companies and thereby causes a decline in their quarterly performance. As investors and analysts analyse how a particular company is doing before investing, a consistent decline in earnings leads to investors losing faith. Such a negative sentiment, if widespread across sectors, can trigger a crash in the stock market.
Furthermore, inflation is a silent killer of market rallies. Rising inflation prompts a series of corrective actions. Interest rates and inflation have a direct relationship; central banks use interest rates as a tool to curb rising price levels. With increasing inflation, interest rates also soar. As interest rates rise, households have fewer funds to invest in the market, reducing the demand for securities and pushing the stock market down.
Currently, inflation remains a concern across the globe. We witness increasing interest rates as well as fluctuating unemployment levels in major economies. These macroeconomic factors are classic precursors to market volatility.
2. Monetary Policy and Central Banks
The Government and Central Banks (like the RBI in India or the Federal Reserve in the US) create and tweak monetary policy to adjust the money supply in the economy.
During periods of high inflation, the Central Bank raises interest rates (a “hawkish” stance) to suck excess liquidity out of the system. Thus, with inflation, as prices soar, interest rates soar too. In the past few months, central banks such as the RBI and the Fed have increased interest rates to combat inflation.
Why does this cause a crash?
Cost of Capital: As interest rates rise, the cost of borrowing for companies increases. This hurts their bottom line (profitability), causing stock prices to fall.
Valuation: High interest rates increase the “risk-free rate” (like bond yields). If an investor can get a guaranteed 7-8% return from a bank deposit or bond, they are less likely to take risks in the stock market. Consequently, demand for equities drops.
Before 2008, the Fed cut off its interest rates to beat the recession, but as soon as they started increasing the rates, the housing bubble burst, leading to the 2008 global financial crisis. It had a massive negative impact on stock markets globally.
3. Global Economic Interdependence
We live in a hyper-connected world. The economies of all countries are interdependent in terms of trade, supply chains, and financial activities; therefore, they are all affected by global economic conditions. This is often referred to as the “Butterfly Effect” in economics.
For example, the Indian market attracts a large amount of international investment. If the US economy enters a recession, US investors might pull money out of emerging markets like India to cover losses at home or to move to safer assets like gold or US Treasury bonds. As a result, global economic developments have a direct impact on the level of investment in India, resulting in changes in the Indian stock market. A crash on Wall Street often leads to a gap-down opening on Dalal Street the next morning.
4. Natural and Man-Made Disasters
Natural as well as man-made disasters are potent causes of a stock market crash. This category includes everything from floods and earthquakes to terrorist attacks, wars, and pandemics.
The most recent and vivid example is the March 2020 crash. As the spread of COVID-19 became more apparent, the economic outlook for India and other countries became increasingly bleak. It wasn’t just a financial crisis; it was a supply and demand shock.
Supply Shock: Factories closed, stopping production.
Demand Shock: People stayed home, stopping consumption.
Companies began safeguarding profit margins through layoffs, while investors began dumping equities as Governments announced travel restrictions, obligatory business shutdowns, and quarantines. This led to a severe drop in major Indian stock indices such as the SENSEX and NIFTY 50 from February to March 2020. The uncertainty of “when will this end” drives the panic during such disaste1rs.2
5. Specula3tion and Asset Bubbles
Speculation occurs when investors buy a particular asset or security not because of its intrinsic value, but with the hope that its value will rise rapidly, allowing them to make a quick profit by selling it off.
In the stock market, speculation is common, but excessive speculation is dangerous. Investors focus only on the price sensitivity that a security has shown over time and ignore the fundamentals of the security (like P/E ratio, book value, or earnings).
Increased interest in a particular sector (like the Dot-com boom in the late 90s or the recent cryptocurrency surge) typically leads to a bubble. Investors pour money into a sector based on hype or future performance predictions that are unrealistic. However, markets eventually correct themselves. If the performance falls short of expectations and the hype fails to match reality, the bubble bursts.
When the bubble bursts, a huge sell-off happens. With increased selling pressure, the value of the assets keeps falling, leading to a panic spiral and eventually a major market crash. The housing bubble in the US, fueled by speculation on property prices, is the classic example that led to the 2008 crash.
6. Geopolitical Factors
Stock markets despise uncertainty, and nothing creates uncertainty quite like geopolitical conflict. A particular country’s market may be affected by an event in another country due to trade links or energy dependence.
For instance, the Russia-Ukraine war hindered economic activity globally. India, being a major importer of crude oil, was vulnerable. On February 25, 2022, the day Russia attacked Ukraine, Sensex fell 2702 points, and Nifty ended at 16247.
War disrupts supply chains and causes commodity prices to rise. After 2014, crude oil prices hit a record high of over $130 per barrel in March 2022 due to the conflict. High oil prices increase the current account deficit for importing nations like India, weakening the currency and causing stock markets to fall.
7. Excessive Leverage (Margin Trading)
Leverage is a double-edged sword. It is a mechanism to invest using borrowed money.
How it works:
You can invest Rs. 10,000 in the stock market using your own funds. If the return is 10%, you make Rs. 1,000. However, if you use leverage (borrowing Rs. 10,000 at 3% interest) and invest a total of Rs. 20,000, a 10% gain yields Rs. 2,000. After paying Rs. 300 interest, your net profit is Rs. 1,700—significantly higher than investing your own money alone.
The Risk:
Leverage becomes perilous when the market turns against you. Excessive leverage in the system creates a fragile market. In a market correction, if stock prices fall, brokers issue “Margin Calls,” demanding investors deposit more cash. If investors cannot pay, brokers forcibly sell their positions to recover the loan.
This forced selling drives prices down further, triggering more margin calls for other investors. This chain reaction can turn a small correction into a full-blown crash.45
8. FII Sell-offs (Foreign Institutional Investors)67
FIIs are foreign investment banks, hedge funds, and mutual funds that inv8est in the Indian stock market. They9 are often the “movers and shakers” of the Nifty and Sensex.
When FIIs buy, there is a huge capital inflow, and the market moves up. However, FIIs are generally “fair-weather friends.” Many factors can lead to a fall in their demand:
Rising interest rates in the US (making US bonds more attractive).
Depreciating Rupee (which erodes their returns when converted back to dollars).
Political instability in India.
Continued selling by FIIs puts immense pressure on the stock market. Since October 2021, there have been phases where FIIs have been net sellers, pulling out thousands of crores. This sustained selling pressure creates a bearish trend and can trigger a crash if domestic investors (DIIs) cannot absorb the supply.
To know more about the importance of FIIs in the Indian stock market, read our detailed article on FIIs impact on Indian stock market on the Teji Mandi blog.
9. Panic Selling (Psychology)
Perhaps the most human reason for a stock market crash is panic. Behavioral finance teaches us that the pain of a loss is felt twice as intensely as the joy of a gain.
Stockholders who are concerned that the value of their investments is in jeopardy will sell their shares to preserve their capital. As prices begin to fall, the panic spreads like a virus. Without a proper analysis of why the prices are falling, a majority of the investors tend to follow the herd.
This “herd mentality” causes a domino effect. Even quality stocks with strong fundamentals get hammered as investors liquidate everything to sit on cash. Panic selling turns a manageable decline into a catastrophic crash.
As you can see, there are a huge number of factors that affect the performance of a stock market. With so many forces at play—economic, geopolitical, and psychological—it may be impossible to completely prevent a crash. However, there are ways to mitigate the downfall. Let us see how regulators manage this.
How is a Stock Market Crash Controlled?
While you cannot prevent the stock market from collapsing entirely, Governments and Exchanges have established specific controls to prevent total market instability and give investors time to cool off.
Circuit Breakers:
Introduced in India in 2001, circuit breakers are the primary defense mechanism. As soon as the regulators of a stock market sense an emergency situation—specifically a rapid drop in indices—they activate circuit breakers to prevent markets from collapsing further.
This is essentially a “time-out” for the market. Employing a circuit breaker means that trading is halted for a particular period in the stock exchange.
10% Movement: If the index moves 10% before 1:00 PM, trading halts for 45 minutes.
15% Movement: If the index moves 15%, trading halts for 1 hour and 45 minutes (depending on the time).
20% Movement: If the index drops 20% at any time of the day, trading is halted for the remainder of the day.
These halts prevent the “panic spiral” mentioned earlier, allowing information to be digested and emotions to settle.
What Should You Do During a Stock Market Crash?
When the screens turn red and headlines scream “Market Bloodbath,” it is natural to feel anxiety. However, wealth is often transferred from the impatient to the patient during these times. If the stock market plunges, consider the following strategies:
1. Don’t Panic, Don’t Sell
First and foremost, do not sell out because you are panicking. It is challenging to keep your composure as your portfolio’s value plummets. However, realized losses occur only when you sell.
Selling is rarely a winning strategy while prices are declining. Markets tend to revert over time (mean reversion). History shows that every crash has been followed by a recovery and a new all-time high. Selling while shares are low locks in your loss and prevents you from participating in the eventual recovery.
2. Differentiate Price from Value
Keep in mind that price drops might be brief, and prices can swiftly rise. Use this time to analyze your holdings. Is the business fundamentally strong? Do they still have a competitive advantage? If the answer is yes, the drop in stock price is an opportunity, not a threat.
3. Buy the Dip (Strategically)
As Warren Buffett famously said, “Be greedy when others are fearful.” A crash offers high-quality stocks at discount prices. You can take the time to analyse good stocks and buy them to profit in the long run. However, avoid trying to “catch a falling knife”—meaning, don’t invest all your cash at once. Invest in tranches as the market stabilizes.
4. Asset Allocation and Defensive Stocks
Having a solid defensive stock mix in your portfolio is one advanced strategy. Defensive sectors include FMCG (Fast Moving Consumer Goods), Pharmaceuticals, and Utilities. People continue to buy food, medicines, and electricity regardless of the economy. These securities are less affected by market disruptions compared to high-growth tech or metal stocks.
Thus, it is always recommended to have a well-diversified portfolio across different asset classes (Equity, Debt, Gold).
5. Continue Your SIPs
If you are a mutual fund investor, do not stop your SIPs (Systematic Investment Plans). In fact, a crash is the best time for a SIP investor because you accumulate more units for the same amount of money (Rupee Cost Averaging). When the market recovers, these extra units will generate higher returns.
The most important way to safeguard your investments is to have a grip on your emotions during phases of massive market fluctuations.
Get more detailed tips to pull through in a stock market crash in our article on ‘how to control your greed in a bull market and gain confidence in a bear market’ on the Teji Mandi blog.
In Conclusion
Markets have a natural upward and downward cycle. While stock market crises can be devastating in the short run, economies recover, and markets eventually soar to new heights. The 2020 crash was followed by a massive bull run in 2021—a perfect example of market resilience.
This is a compelling argument for investing in the long term. Time in the market is more important than timing the market. Building a strong portfolio that can withstand market drops and provide a healthy mix of assets will help you get through the tough times.
Navigating a stock market crash requires expertise, patience, and a cool head. If you find yourself overwhelmed by market volatility, it might be time to seek professional help.
