Why Does the Stock Market Crash?

stock market crashAre We Doomed to Repeat the 2008 Stock Market Crash?

As smoke cleared from the 2008 stock market crash, economists emerged from the wreckage questioning everything they knew. They had believed the stock market was destined for balance, that it tended towards stability, but history showed otherwise.

The conventional view of economics held that investors acted reasonably. These mythical investors would bring stock prices into harmony using their perfect information and flawless logic, bringing order and equilibrium to the market. That’s how economists thought the world worked.

Boy, were they wrong. Shocking as it may seem to the sacred principles of economics, investors, and indeed all people, are not fully rational. They get swept up in emotion, make nonsensical decisions, and treat guesswork as a way of life.

Now, I should be fair. Most economists would be willing to admit that, but they don’t follow through to explain why stock markets crash. They’ll still insist that it was an anomaly caused by this one thing, and it only happened this one time.

But like I said, history tells a different tale. Although the jury is still out on this one, it looks like stock markets may be stuck in a permanent cycle of boom and bust. (Source: “The Minsky Moment,” The New Yorker, February 4, 2008.)

Markets are Great, but Unstable

Most often, stock market crashes are caused by overconfidence. Once economic conditions get too cozy, financial firms get callous about risk and funnel cash into speculative investments. Then comes the groupthink.

The bubble is formed when more and more investors mimic a trend, whether it’s buying technology stock (like in the 2000 crash) or mortgage-backed securities (like in the 2008 crash). When everyone is following the crowd, no one can see where they’re going.

If economists were right about investor behavior, then the due diligence on mortgage-backed securities would have revealed them to be toxic assets. Many of the financial products that had been rated as “AAA” were simply composites of lower-grade assets, yet barely anyone noticed in the run up to the financial crisis.

The entire history of the capital market is riddled with asset bubbles. In 17th-century Holland, tulips became a type of investment. The flowers were new to the upper classes of Dutch society; therefore, they became a treasured possession. Everyone believed their value could only increase (that’s when you should start to worry), so prices skyrocketed. (Source: “TULIPMANIA: How A Country Went Totally Nuts For Flower Bulbs,” Business Insider, September 16, 2014.)

Pretty soon, Tulipmania ran out of steam and prices fell just as sharply as they’d risen. That’s usually how it goes. When the self-sustaining optimism reaches a breaking point, doubt creeps into the market and casts a shadow over the asset’s value. (Source: “The Minsky Moment,” The New Yorker, February 4, 2008.)

From there on in, it’s simply a race to the exits.

Rethinking Stock Market Crashes

Economists underestimate the power of mob mentality in shaping the market. There is a feedback loop between investor sentiment and stock prices, which shouldn’t surprise anyone with the tiniest understanding of human nature.

The price rises and some people make money, so more people buy and the price shoots up further. And so on and so on. The pattern keeps repeating till it reaches a fever pitch, and then…BOOM.

It’s happened before and it will happen again. That’s simply how markets work: they create stock market bubbles that will eventually lead to a stock market crash.