Diversifying your portfolio is essential if you want to build wealth. However, putting all of your money into the stock market isn’t the best idea. That is because every few years there is a stock market crash. Many things can cause these crashes. Before we begin looking at the causes, let’s define what a stock market crash is.
The Many Faces of Stock Market Crashes
Stock market crashes can devastate your monthly dividend stocks. There is not an official definition of a stock market crash. However, most investors would say that a 10% drop in the stock market would constitute a crash. Anything over that is even more severe. A stock market crash is not when the value of a single company’s shares drop. It must be the entire index that falls.
Minimal Profits
Profit margins are crucial for a business to thrive. Throughout history, many companies have gone insolvent because they could not maintain good profit margins. Insolvency can trigger the crash of an individual stock price. However, this can cascade into other stocks. Ultimately, the entire stock market could devalue.
Excessive Debt Loads
Credit is king. At least that is what people say. Unfortunately, when companies take on excessive debt loads, it can become a burden. When this burden becomes too much for the company to maintain, it could also lead to a devaluation in their stock price. Consumer debt loads are also important to consider. Companies need to have customers if they want to stay profitable. When consumer debt loads grow too large, people do not have money to spend. This can lead to devastating effects on the stock market.
Technological Disruption
Falling stock values are a hallmark of stock crashes. We do not usually associate them with advances in technology. However, many companies become victims of technological disruption. One great example would be companies that produced wagons. A hundred years ago, these would have been the dominant form of transportation. Today, the story is much different. We tend to think of the automobile industry as boosting the stock market. For the most part, they do. However, when the automobile first entered the market, it displaced all of the wagons. Thus, all of the companies that produced wagons went under.
Disasters and Emergencies
Disasters and emergencies can both lead to sharp drops in the price of a stock. It does not matter what kind of disaster it is. The most recent crash in the stock market was the result of a viral pandemic. Ultimately, anything that disrupts the economy can lead to a crash. Weather events are another common disaster that leads to devastating financial effects. Hurricanes can destroy infrastructure making it impossible to conduct business as usual. Any disruption to business can directly impact the value of a stock.
Monetary Policy
The federal reserve is the central bank of the United States. Their charter gives them full control over the US dollar. They decide how much to print and what interest rates will be. Sometimes they raise interest rates. Typically, this is done to combat high inflation. Unfortunately, an unintended side effect is often a sharp drop in the value of stocks. Monetary policy permeates the economy. You may not even realize that it plays such a large role. If you want an advanced warning, check out the bulletins from the federal reserve regularly.
Mass Psychology
Finally, mass psychology plays an instrumental role in all crashes. The value of a stock does not decrease unless people decide that it does. When people decide that they all want to sell their stock at once, it leads to a price drop. There are many reasons people might decide to sell their stocks. They could need the money, or they may just not want the stock anymore. However, when millions of people decide the same thing all at once, it can crash the entire stock market.
Learning From the Past
On average, the economy crashes at least once every decade. Sometimes it will continue expanding for longer than that. Our most recent expansion lasted for twelve years. However, occasionally stocks will crash quicker. If we look at history, we find that the shortest time between downturns was only four years. It’s impossible to predict with one hundred percent accuracy when the next one will occur. On the other hand, we can be reasonably certain that one will occur at some point.