Inevitably, Why Markets Crash.
Updated: May 5, 2020
As investors, you probably have wondered why markets crash and how to profit from them. From the Tulip Mania crash back in the 1600s to the housing subprime mortgage crash of 2008, market crashes will always occur and will continue to happen. With this said, since market crashes are inevitable, the only thing you can change is how you react to them.
Why Do Markets Crash?
Although all of the crashes throughout our history seem different in their own aspects, they all contain one similar component: securities’ prices are blown out of proportion before the market crashes. At first, it seems confusing on why the market could ever become overpriced in the first place, but let me explain. A great theory that explains this is the Castle-In-The-Air Theory. This theory states that when optimism builds up in the market, the mass market will commonly build a sort of castle in the air and will think of the probable price rise in the future rather than estimating the intrinsic values of stocks. Because of this, stocks rise for no apparent or fundamental reason except for people’s beliefs in them. As the non-investing population sees these stocks rising at unusual levels, they decide to invest as well to avoid missing out on the opportunity. This causes prices to increase at even more extremely high rates, which tempts even more individuals to invest. But, what happens to this bubble after a while? It pops, and because of this, it crashes and takes everyone’s investment returns down with it.
Why Do Professional Investors Keep Investing Even If They See The Bubble?
I know it seems counterintuitive for a professional investor or fund manager to be investing when they know the market is in a bubble waiting to burst. However, they continue investing because of the Greater Fool Theory. The Greater Fool Theory insists that it doesn’t matter whether you’re investing in an extremely risky market or not as long as you can sell it at a higher price than it was bought at to a “greater fool.” This greater fool then tries to sell the security at an even higher price to an even greater fool. Fund managers try to wait until the very last minute to gain the highest return before selling it to this so-called “greater fool.” However, this is very difficult to attain because timing the market proves to be one of the most arduous tasks to accomplish in the stock market. So, what often happens is these fund managers, even though they are considered professionals, fund’s tank with the rest of the market. (Note: When saying this, I am not saying all fund managers to this, but it is common.)
Do We Know Exactly When The Market Is Going To Crash?
Although I really wish I could answer this question for you, I can’t. This question is extremely hard to answer because these bubbles aren’t built by logic, so the date that the market will crash cannot be discovered with logic. Nobody knows when investors will pull out their cash, but when it does happen, it strikes fear in the entire market, which causes panic selling to build the crash. Even though nobody knows exactly when the market is going to crash, if one looks deeply, it is possible to find the bubble forming.
So If I Do Not Know When The Market Is Going To Crash, How Can I Profit From It?
Since it is possible to see when a bubble is forming, it is possible to not lose everything from a market crash and to even profit from it. If and when you see the bubble start to form, you must do two things. First, it is best to create a watchlist of solid companies (stocks) that you will buy upon the market crashing. Second, start to slowly sell some of your investment securities and turn them into cash. By slowly,but continually, doing this, you will still be gaining returns from the bubble, but you will not lose it all if it bursts. After an unknown period of time, the market will crash, and from there you will start slowly buying back into the market. This will be exceptionally hard to accomplish because at this time everyone, including financial professionals, will be screaming to sell when you are buying, but if you do accomplish this feat, you will profit from the next crash and every crashing following.
What To Not Do In A Market Crash!
The worst thing you can do once the market has already crashed is selling your investment. Although it might seem that you’ve lost a lot of money, you truly haven’t. Yes, you’ve lost money on paper, but if you are diversified properly, your investment will grow again and regain its value. However, if you sell your investment, your money will be lost and will have zero chance of regaining it anytime soon.
Overall, we can see that market crashes are inevitable, but they can be profitable and prove to be more profitable than almost anything else in the stock market if you use it wisely.
Disclaimer: I am not a financial advisor, so please review all of this advice with your CFP or financial advisor first.