What Is a Stock Market Crash?

Paul Atherton |
09-02-2021
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Man watching stock prices intently
Finance experts are always worried about the next market crash. But what does that really mean?

Before we talk about a stock market crash, it’s a good idea to talk about what a stock market is and how it works.

“The Stock Market”—the clue is in the name.

A stock market is a marketplace, where instead of buying and selling food goods, people are buying and selling stocks and various other financial securities.

There are many stock markets in the world, but perhaps the most well-known, the most quoted, and the largest (meaning the stocks represented have the largest market capitalisation), is the New York Stock Exchange—or NYSE.

Locally, it’s known as ‘the big board’.

The big board is where stocks, bonds, mutual funds, derivatives and exchange-traded funds all traded.

The NYSE is an ‘old school market’, meaning it’s an open auction market. It’s where real people trade. The NASDAQ may be computer based, but the essence of the trade is the same.

On the NYSE, you see people yelling at each other on the trading floor. The people yelling at each other are buyers and sellers who are offering competitive offers at the same time for a stock, bond, etc. You’ve probably seen this in the movies—yep, it’s real.

They use these competitive offers to match bids and offers that are paired together and fulfilled.

A ‘bid’ is an order to buy; it’s how much you are willing to pay for something. An ‘offer’ is the price you are willing to sell your stock.

Because there is always a price, bid that you would be willing to sell (offer) your stock. With enough people trading daily, the system of matching buyers and sellers works exceptionally well.

Mechanically, it goes like this:

You, sitting in your home or office, enter an order to buy or sell, say, big brother stock (BBS), listed on the NYSE.

Now, you can’t just look up the NYSE contact number on Google and give them a call.

You need to have someone that has access to the trading floor, where all the buying and selling happens.

Traders Shaking HandsHow do you find someone with access to the trading floor?

The good news is that over hundreds of years, stock market access mechanisms are well-documented, clean, and mostly inexpensive.

You can get a ‘broker’— a real-life human that you can chat to to buy/sell your stocks.

But there’s an easier and cheaper way than calling a broker.

It’s easy-peasy and super inexpensive.

What is it?

Get your own online trading account.

By either of these mechanisms, your buy (or sell) order reaches the floor of the NYSE.

Even if you are trading all the way from Australia, eventually, it must hit the NYSE trading floor and be dealt with by the floor brokers, market makers, and specialists who help execute the transaction.

I won’t go into the details on how the differences in how these people work, but together they facilitate all transactions to buy and sell.

They are matching people that have decided one morning that they want to sell their stock to someone that wants to buy.

Remember, the world is a vast place; there are millions of holders of these securities (stocks, bonds etc.) and some will decide to buy or sell based entirely on their circumstances.

It might be a feeling, a rebalancing, a decision to move to another stock.

Perhaps they just woke up with indigestion. Who knows?

The reasons can be unlimited. And the markets are diverse enough, driven by a diverse enough group of people, that at the end of the day the ‘correct market price’ will be reached.

Don’t believe me?

Have you heard of the jellybean test? It’s a test where an enterprising teacher did the following:

  • He brought in a large glass jar full of jellybeans.
  • He passed the jar around the class and let each student write down their guess of the number of jellybeans on an index card. They developed these guesses independently.
  • He collected the cards from the class.
  • He then asked students individually to provide their guesses publicly. They could keep their original guess (from the index card) or change it based on what they heard from other students. He jotted down their responses on the board and tabulated the results.

Here were the results from his experiment:

Average from index cards: 1771

Actual number in the jar: 1776.

This has been replicated hundreds, perhaps thousands, of times. The accuracy of this test is astounding.

Markets work similarly.

Like I said before, the daily group of traders is large enough, and diverse enough, that the average across the day will find the ‘correct market price’.

“”A crash is herd mentality at its most painful.””

What happens when the stock market crashes?

 

A crash is where something happens that’s big enough to catch a significant enough ‘market audience’ that the trades are going mostly one way. Sell.

Imagine, you are a trader on the NYSE trading floor and you yell out that you have hundreds of sellers of BBS.

Anyone want to buy at $xxx?

All he hears is crickets.

Anyone wants to buy at $yyy?

Crickets.

Oh shit. There are no buyers.

But now, there are a lot of sellers.

And the market must keep ‘falling’ until it finds someone willing to buy at a new lower price.

Sometimes much lower.

But who wants to buy on a market crash day?

A crash is herd mentality at its most painful.

When I used to describe this in a large classroom with 100 or so students, I would explain a market crash like this:

Imagine, if one person in this room of 100 got up and ran out yelling and screaming. What would you do?

Probably nothing. Perhaps look a bit bewildered.

Now imagine two people did it. What would you do?

Probably the same, but maybe you’d feel just a tinge of unease.

Now, imagine a full 20% of the classroom, in this case 20 people, ran out yelling and screaming.

What would you do then? What do you think the rest of the class would do?

Who would have the guts to stand their ground and not move under that circumstance?

Not many.

Most likely, those 20 people would result in 100% of the people running out of the room. That’s the herd.

How often do stock market crashes happen? How big are they?

Over the last 100 years, there were 85 days when the S&P500 (The US Top 500 market capitalised stocks) declined by over 5%.

A market crash of 10% happened four times. 15% once. And 20%+ once. That was the big one. Amazing.

So, crashes happen. But they are mostly very short-lived, and the upside from a crash can be significant.

In my classroom analogy above, eventually, everyone comes back in the room.

Because that’s where the fun is.

To recap…

  1. A stock market is a place where stocks (and other securities) are traded with the entire world.
  2. The mechanisms to access the stock market are well established and easy to use. Try a broker or an online trading account.
  3. Stock market crashes happen, but rarely, and they have always recovered.
  4. A stock crash is herd behaviour. But they have always come back to the room.

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Who is Paul Atherton, That Wall Street Guy?

An ex-Wall Street advisor who worked with major players in the global financial industry for over 30 years, Paul’s mission is to help regular people reclaim their wealth and financial security.

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