Why The Stock Market Crashes

With all of the articles, research, and opinion pieces out there it can make it seem like the stock market is some sort of mythical creature. People are always talking about “what will the stock market do next”? “How can we try to predict what it will do”? “How do we please the stock market so it doesn’t crash”?

These are all legitimate questions because people are just trying to understand what’s going on. So much of what happens with the stock market is seemingly just random. Either lucky or unlucky. But is it? Let’s take a look at what powers the stock market. Why does it grow and why does it crash?

Knowledge is power

“If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.” –Sun Tzu

It might seem a little dramatic to open with a quote about battling the enemy but we think this quote pretty accurately describes investing. In this scenario, the stock market is the enemy and to “defeat it” just means to achieve a satisfactory return.

Understanding yourself (and your financial goals) and understanding the stock market means you have no need to worry.

Understanding your financial goals but not the stock market means you will have moderate success.

Understanding neither what your financial goals are or the stock market means you’re in trouble.

So let’s break it down.

What is the stock market?

            The stock market is essentially just a flea market where people can buy/sell shares of corporations. When we talk about the stock market we are really referring to one of the most common stock exchanges: the Dow Jones, S&P 500, or NASDAQ. These exchanges track prices of specific stocks and are used to monitor the market as a whole.

When you buy a share of a corporation you’re just buying a tiny sliver of ownership. There can be a lot more detail to it but that’s the basic gist. So when you buy a share of stock, you become a shareholder in that company.

 As a shareholder, you’re able to take part in the success (or lack thereof) in a company. You’ll have the opportunity to earn:

  • Capital Appreciation – An increase in the price or value of an asset.
  • Dividends – A sum of money regularly paid by a company to its shareholders.

Generally speaking, when you buy a share of stock in a company you’re hoping that the company performs well and the stock price increases over time. This will mean more money in your pocket.

IT’S IMPORTANT TO REMEMBER THAT STOCK PRICES ARE JUST REACTIONS TO NEWS.

So what causes stock prices to increase or decreases?

What causes the stock market to grow?

Believe it or not, the stock market actually operates under the rules of a free market (with supply and demand). This means that if more people want to buy a stock (demand increases) the price will go up. On the other hand, if more people want to sell a stock (demand decreases) the price will go down.

Let’s look at another example of supply and demand impacting prices. An up-and-coming performer is doing a show and sets ticket prices at $50. The venue sells 100% of the tickets and the show is a success. By the next year, the performer is a huge star and decides to perform the same show except now the same tickets cost $200.

Tickets are selling but then it is announced that the artist was involved in a scandal. Following this news, people boycott the concert. Now nobody is buying tickets but the venue still wants to sell tickets. They decide to discount the tickets to $100 and proceed to sell out the rest of the tickets.

In this scenario, the product essentially stayed the same: the performer’s concert. However, the price changed 3 times. Similar scenarios are happening to companies and their stock prices each day. This is because every day there are new updates for companies.

Here are some of the ways the stock market can grow:

  • A company announces expansion into a new country.
  • A new CEO with a tremendous track record of success is hired.
  • The company reports that they have beaten their earnings from the previous year.
  • The company buys its largest competitor, reducing competition.

What cause the stock market to crash?

There can be a lot of things that cause a stock market to crash. While stock market crashes can be hard to predict, they’re usually not hard to understand.

Here are a few of the main reasons that a stock market might crash:

Investing Irresponsibly: Sometimes investors can get too excited. People buy too much of a company’s stock and drive the price up above what it’s worth. Usually, the market will correct itself but sometimes investor euphoria can lead to a huge crash. Think of an auction block with two people bidding on a house with a market value of $50,000. Each one determined to beat the other and win the auction, they both refuse to stop bidding and accidentally drive the bid up to $100,000 before either backs down. Now the winner owns the house but has drastically overpaid for it.

Economic Factors: Federal tightening – The Federal Reserve can take money out of the economy. This means there’s less money floating around to buy things and create growth. Trade wars – These are usually good for no one.

World Facts: Famine – Can limit the supply of products worldwide, making goods more expensive. War – Also good for no one. Pandemic – A global health crisis can disrupt supply chains and limit people from working.

Remember that the stock market is essentially just the collective reaction to what is happening in the world. If something happens that most investors consider bad, the stock market could crash. OR if something happens that most investors consider good, the stock market will perform well.

 The best decision is usually to examine all of the information and make your own decision! Don’t be afraid to go against the grain.

Author: The Stock Daily News Team

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