Market regulators are accusing a British national of almost single-handedly causing a “Flash
Crash” to American stock markets in 2010.
During the incident, the Dow Jones Industrial Average dropped about 9%, and lost more than
$1 trillion dollars in minutes.
Fortunately, stocks rebounded relatively fast after the shock, but we wanted to know, what
does it take to crash a stock market?
Well, there have been countless financial “crashes” throughout history.
They even go back to the 1600s when modern stock exchanges were first evolving within
the European trade economies.
A crash represents a steep, sudden decline in the value of market prices, and they can
often lead to an economic depression.
The most devastating crashes are usually the result of an overly-inflated market, also
known as a “bubble”.
In short, the value of a stock is dependent on what people think it will be worth in the
future.
When the economy is good, or there are other motivating factors, investors expect their
stocks to rise in price, which in turn does increase their value.
Investment bubbles occur when prices of market shares are driven upwards past their real
value.
According to some market theorists, a bubble is encouraged by a “herd mentality”, where
people first jump on the bandwagon of a profitable stock, and then, when the bubble bursts, they
engage in panic-selling.
The most famous example of this was during the 1929 American Stock Market Crash.
In the years after World War I, optimism in the economy inspired many to take on risky
loans, and invest in stocks.
But when the economy slowed down, the public began to doubt the market’s longevity, and
started selling their shares - at first slowly, and then in droves.
Market prices went into freefall, and with no fail-safe rules, the market inevitably
crashed.
Stock markets can also be “spooked” into a decline or a crash following catastrophic
events.
For example, San Francisco’s massive 1906 earthquake is thought to have played an integral
role in the financial panic of 1907.
During that time, the market sank to about 50% of the previous year’s valuation.
Additionally, In 2001, after the September 11th terrorist attacks, the stock markets
were closed for almost a week.
In the first five days back, the markets faced a loss of about $1.4 trillion dollars.
The digital era has also introduced new threats to the stock market in the form of “high
frequency trading”.
HFT is when thousands of trades are carried out by computers in fractions of a second.
The swiftness of computer programs at buying and selling puts traditional traders at a
disadvantage.
Also, HFT creates potential volatility in the stock market.
Computer programs that are designed to automatically respond to price points can trigger mass selling
before anyone has time to react.
This was said to have contributed to the 2010 Flash Crash, after a large enough downtick
in stocks caused many HFT programs to further withdraw, leading to a drastic crash.
After that event, government regulators imposed new laws, called “circuit breakers”, which
temporarily “pause” trading if a stock falls by a certain percentage, usually 10%
or more, within a short time.
These safeguards give traders breathing room to reexamine their options instead of panicking
and selling everything before the stock bottoms out.
The Securities and Exchange Commission works hard to regulate the wild swings of the stock
market.
But for the modern era, stock markets remains more volatile, and susceptible to crashes
than one might ever think.
Investing is a pretty risky thing to do, but sometimes big risks can have even bigger rewards.
To learn why Africa is such a hotspot for foreign investment right now, check out our
video here.
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