Most wrongly used the term in the stock market.
Trader: I don’t know what I’m going to do.
Me: Why what Happen?
Trader: The stock market crashed.
Me: How do you say that?
Trader: Nifty opened with Gap Down 80+ points.
Trader: I am going to lose all my open position and investment. Do not know what do do about it.
Me: What makes you say its a market crash. It could be a Stock Market Correction.
Trader: I making such a huge loss in my position and Index has opened almost .80 % down. If it is not crash what else it could be.
Me: Stock market Correction is quite often misinterpreted as Crash. Clarity on this will change your outlook of the market and will improve your decision making.
DEFINITION OF MARKET CRASH
Market crash can be identified when valuations are at the peak and creating Bubble in the market. Another indication of the stock market crash is when the market falls across the sectors and the regulators are forced to halt the trading activity then we can definitely conclude as Market Crash.
I love this definition from Wikipedia.
A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative stock market bubbles. Stock market crashes are social phenomena where external economic events combine with crowd behavior and psychology in a positive feedback loop where selling by some market participants drives more market participants to sell. Generally speaking, crashes usually occur under the following conditions:a prolonged period of rising stock prices and excessive economic optimism, a market where P/E ratios exceed long-term averages, and extensive use of margin debt and leverage by market participants.
The stock market usually follows a life cycle. And when on understands this life cycle only then market crash can be easily interpreted and predicted.
This life cycle has many stages we will discuss only two in this article.
First, comes the Bubble and then the Crash.
Why? (Some silly people still ask)
Extreme Greed and Delusion leads to Bubbles and when they the bubble bursts it crashes.
Below is the chart where “y’ axis is Valuation and “x” axis is Time.
WHAT IS BUBBLE?
The stock market crash is an output of stock market bubble. The market crash is the result of the stock market bubble. So let us start to understand what creates the bubbles. Usually, mania phase starts with smart marketers promoting their financial products and returns that few section of people have got from trading or investing in stock market.
The ideal time for promotion of the stock market, financial products or advisory is when the returns are at the peak. When the performance is high they also have a higher spending power for marketing and promotion of their products.
This is then picked up by media which blows out of proportion. Media basically create public enthusiasm for investing in stock market and get returns to fulfill their dreams. This is then followed by Greed to get delusional returns.
Greed leads to higher deviation from the long-term mean. Also, valuation is at its peak. Some of the parameters for measuring the valuation is high is Price to Equity ratio. It is also known as PE Ratio.
In the above entire process, the bubble has been created.
High valuation can be sustainable if the pe ratio is justifying the same. Pe ratio expansion and contraction comes into play. During the period of high valuation if the pe expands which gives an impression that the high market valuation is not justifiable.
At the same time if the pe contracts then this gives room for more growth and rise in valuation. In high growth phase if the pe keeps reducing then results are justifying the market valuation.
CAUSES OF CRASHES
Now when the market has reached unexplainable valuations cause due to public greed. Any negative economic event, catastrophe, crisis, political crisis etc can be the cause of panic. The extended bull market is created by irrational exuberance or public greed has already taken the price above their real worth.
Black box trading or High-frequency trading in recent times have caused flash crashes. The cause of panic or trigger of panic can come from anywhere.
HOW TO INSULATE FROM MARKET CRASH
There are many ways to insulate from the market Crash.
The Right person is to contact your financial advisor to know which method suits you the best. Some of the ways are mentioned below.
- Invest Partially in Gold
- Invest Partially in Real Estate.
- Get your portfolio Hedged.
- Buy Guarantee (Bonds, Debenture, Fixed Deposits etc)
- Clear your Debts
- Loss Harvesting
- Investment Diversification
- Cash (Most Important)
Don’t start investing until you are ready for the market crash.
Don’t only invest in Stock Market. Have a second source of income.
And most importantly, hedging your investment portfolio.
I want you to do something for me right now: Leave a comment and mention at least one time when you have mistaken a correction as a crash in your stock which was otherwise meant to be a long-term investment.