What Happens to Peoples Money When The Stock Market Crashes?

A stock market declines and investors can lose a lot of their wealth, i.e., the DJIA lost 50% of its value during the 2008 crisis, which meant trillions of lost market value.

What Happens to Peoples Money When The Stock Market Crashes

Decreased Value

Historically, a stock market crash causes the value of investments such as stocks, mutual funds, and ETFs to plummet. History is replete with such examples and many of them testify to the disastrous consequences on investment positions.

The Wall Street Crash of 1929 is always a story never to forget, best known as Black Tuesday. The infamous October 29, 1929, “Black Tuesday” whacked another 12% off the Dow Jones Industrial Average (DJIA). The market continued to fall even more over the next few months, falling almost 90% by 1932. Wealth literally evaporated before the eyes of investors who were holding stocks as stock prices dropped precipitously.

Dot-Com Bubble (2000): A similarly major crash occurred in the early 2000s because of the collapse of the dot-com bubble. The mark-to-market values of noted on your account can suffer the same fate of dot-com companies when the Nasdaq Composite index — heavily laden with technology stocks — plummeted 78% from March 2000 to October 2002. Companies that were worth hundreds of millions to billions went bankrupt and ended basically worthless. Trillions of dollars evaporated from the market in this time period for investors.

The global stock markets saw a huge sell-off following the 2008 Financial Crisis. Between October 2007 and March 2009, the DJIA lost over 50% of its value, and billions of dollars in market capitalization were wiped out. In other words, the potential for insolvency of major financial institutions, with global repercussions. The S&P 500 was down more than 50% during this time as well.

Impact of the COVID-19 pandemic (2020) — The COVID-19 pandemic began in early 2020, and this led to a swift sell-off in worldwide stock markets. Indeed, the S&P 500 tumbled 34% in just 23 trading days from February through March. While that market experienced a rapid rebound, the crash was a sobering reminder of how swiftly market values can plummet, given the right unexpected catalyst.

Paper Losses vs. Realized Losses

In a stock market crash, investors have to deal with two main types of losses – paper losses and realized losses. Knowing these two are different can have a material impact on how an investor thinks about their strategy and their financial future.

Paper Losses—These take place when the value of an investment falls, but the investor has not closed the position. During periods such as the 2008 financial crisis, an investor with a $100,000 equity portfolio might only have $50,000 left in value. While this $50,000 reduction is nothing more than a paper loss at this point (because the loss is not crystallized until the investor actually sells), the investor still experiences a loss when a security that he invested in goes down in price. However, this drop still exists only on paper and may change depending on the market.

Realized Losses – These are sustained when an investor sells an asset for less than its purchase price. For example, take the investor from 2008, who, facing this reduction in value, decides to sell their stocks for the reduced $50,000. They ultimately have lost $50,000. Realized losses are very concrete and will affect an investor’s taxable income and financial planning.

Historical Examples and Data:

  • The crash of the 1929 stock market, known as Black Tuesday. By selling the stocks because of the panic, investors locked in real losses. Investors who kept their investments watched as their investments fell to paper losses but knew they could theoretically get their money back if the market ever leveled off. During this period, the DJIA fell by 90% from its peak and wiped out large amounts of investor wealth.
  • Dot-Com Bubble (2000—2002): The Nasdaq Composite index lost 78% of its value as it collapsed. Tons of investors that had been in technology stocks ended up giving back most or all of their gains during this period. Conversely, those who stuck with their investment saw massive paper losses but had the opportunity to make back those losses and then much more in the coming years if the companies survived and rebounded.
  • 2008 Financial Crisis: From October 2007 to March 2009, over 50% of its value was lost by the DJIA. Those investors who panicked and sold their assets during the downturn lost BIG. But those who held onto investments with unrealized paper losses enjoyed a ride back up when the market inevitably recovered. For example, an investor who kept even an S&P 500 index fund from the top in 2007 would have lost a significant amount of value but would have eclipsed the previous peak in value by 2013.
  • COVID-19 Pandemic (2020) — The rapid slide of early 2020 in the stock market dropped the S&P 500 by 34% in a mere 23 trading days. During this period, investors who went to sell lost money, locking in the reduced price. Meanwhile, those who stayed in their investments saw paper losses but were able to recoup them as the market surged ahead, culminating in new record highs for the S&P 500 by the end of the year.

Impact on Retirement Accounts

When a stock market crashes, the damage it does to your retirement account can be really dramatic, often cutting a big chunk out of your retirement nest egg. These accounts — 401(k)s and IRAs — are mostly in the stock market and thus are at great risk every time market levels dissipate.

Historical Examples and Data:

  • ARMs made a lot of sense until the 2008 financial crisis when the average 401(k) balance fell 31% from $65,000 to $45,000. That plunge helped push the retirement age of many near-retirees out or forced them to reconfigure their entire financial plans. The crisis laid bare the susceptibility of retirement accounts to market volatility and the importance of a well-rounded investment plan. Afterward, many investors shifted to more conservative investment vehicles to help shield their nest eggs from future market volatility…
  • Dot-Com Bubble (2000-2002): Though the dot-com bubble exploded, the bursting created a tremendous amount of damage on retirement accounts. The Nasdaq Composite fell 78% from its peak and many tech-heavy retirement portfolios were decimated. Those speculatively betting the farm on tech shares simply had to wear the consequences in the form of massive losses of their retirement savings. However, those who invested in many different types of investment sectors did better, but it was hardly pretty.
  • COVID-19 Pandemic (2020) — The COVID-19-induced market crash early in 2020 resulted in the value of retirement accounts plummeting drastically. Case in point, the S&P 500 plunged by 34% in a mere 23 trading days. For instance, an investor with a 401(k) balance of $200,000 may have seen their account value plunge to around $132,000. Although the market quickly rebounded — recovering in three weeks more than one-half of the prior losses — the initial blow created widespread fear among retirees and those near retirement age.

Steps to Mitigate Impact:

  • Diversification: Spreading investments across a variety of asset classes, such as stocks, bonds, and real estate, can help mitigate the effect of market crashes on retirement accounts. A combination of stocks and bonds fared better than stocks alone during the 2008 crisis.
  • Scheduled Rebalancing: Rebalancing retirement accounts on a set schedule helps to keep the portfolio’s asset allocation consistent with the investor’s risk profile and long-term retirement plans. This can help soften the downsides when the markets correct. In the case of the 2008 stock market crash, this would mean buying more stocks at lesser prices and selling bonds at higher prices (as part of the rebalancing), thus strengthening the portfolio for the recovery.
  • A Long-Term Point of View: Investors should have a long-term view of investment during market crashes. Markets always recover, as historical data show, and over time, long-term investors stay invested and therefore typically experience their portfolios recovering as well. From the 2008 crisis, for example, it took the S&P 500 around four years to get back to its pre-crash levels, leaving those who were invested the whole time better off.
  • Emergency Fund: Having a separate emergency fund helps avoid taking money from retirement accounts typically when the market experiences temporary downturns. You should have at least six months of living expenses in this fund, which will be a buffer for you in times of economic uncertainties.

Economic Impact

Stock market crashes can impact more than just individual investors. Once the dam breaks, history has shown how that slide can be extrapolated out into economic disarray and spill into people getting laid off, full-time to part-time, and a complete lack of consumer demand that tips the balance of the entire economy.

Historical Examples and Data:

  • Black Thursday, the Wall Street stock market crash of 1929 and catalyst for the Great Depression, was one of the most devastating economic collapses in history. From all-time highs, the Dow Jones Industrial Average (DJIA) plummeted nearly 90%, wreaking havoc on financial livelihood across the board. Over the next two years, unemployment would reach 25% where it had rarely hit 2.5%, with the GDP declining by nearly one-third. The inter-linkages between the stock market and the economy were exposed, resulting in the collapse of numerous banks and widespread poverty.
  • The bankruptcy of Lehman Brothers in September 2008 started a worldwide financial crisis. From October 2007 until March 2009, the DJIA dropped more than 50%. The Great Recession was the nadir of this crisis, with the U.S. unemployment rate reaching a peak of 10% in October 2009. Global GDP growth dropped from 5.4% in 2007 to -0.1% in 2009. This led to a complete collapse of the housing market, with millions of foreclosures and billions in lost wealth. Governments enacted enormous stimulus packages to encourage economic recovery.
  • COVID-19 Pandemic (2020): In early 2020, a stock market crash due to the COVID-19 pandemic led to an economic crisis. The S&P 500 fell 34% in only 23 trading days. The lockdowns, travel bans, and shutdowns brought global economic activity to a halt. The U.S. unemployment rate soared to 14.7% in April 2020, the highest since the Great Depression. Historic fiscal and monetary measures were put in place by governments around the world in the form of stimulus checks, expanded unemployment benefits, and interest rates that were nearly zero, as central banks sprang into action.

Impact on Businesses:

  • Reduction in Investment: During pressed market conditions, firms choose not to invest as they are uncertain and revenues are falling. Business investment in the U.S. fell by 20% during the 2008 recession, causing the recession to deepen.
  • Layoffs and Labor Reductions: Companies often implement workforce reductions as a way to control payroll costs, resulting in higher unemployment. During the Great Depression, unemployment reached 25%, while during both the 2008 crisis and the COVID-19 pandemic, it exceeded ten percent.
  • Bankruptcies: A struggling economy tends to generate more business bankruptcies. The financial crisis resulted in mass bankruptcies, such as the bankruptcy of Lehman Brothers, and led many smaller companies to file for Chapter 7.

Impact on Consumers:

  • Consumer Spending Falls: A plunge in the value of retirement funds can deeply impact family budgets, leading to lower consumer spending. There are few things more deflationary than reduced spending by consumers, which further reduces the economy. During the Great Recession, consumer spending in the U.S. fell by 2.8% from 2008 to 2009.
  • Higher Saving: Consumers save more because of anxiety for the future. The COVID-19 pandemic increased U.S. personal savings to 33.7% as of April 2020. While higher savings are ultimately good, in the short-term, they crush the economy.

Response from Governments and Central Banks:

  • Many Stimulus Packages: Governments often announce stimulus packages to alleviate the financial damage from stock market crashes. In the United States, the federal government enacted the $787 billion American Recovery and Reinvestment Act in 2009 and the $2.2 trillion CARES Act in 2020.
  • Interest Rate Cuts: Central banks universally slash interest rates and practice quantitative easing to stave off crises. The Federal Reserve lowered interest rates to almost zero in both the 2008 crisis and the 2020 pandemic.

Psychological Impact

Stock market crashes leave a psychological impact on investors that makes them panic, become stressed, and often start making irrational decisions. History also shows how such fear and anxiety can further depress asset prices, compound financial losses, and complicate the process of economic recovery.

Historical Examples and Data:

  • Black Tuesday (1929): The stock market crash of 1929 led to mass hysteria regarding investment. Black Tuesday happened on October 29, 1929, when the Dow Jones Industrial Average (DJIA) fell 12%. The panic was such that thousands of out-of-work capitalists hit the roads to offer their supplies, making things even worse. It is reported that as people were driven into financial ruin, suicides went up. This panic was not confined to wealthy investors, as many paid small fortunes in the frontier market of the 1920s.
  • Later in 2008: The Lehman Brothers collapse in September 2008 rocked global financial markets. A 500-point crash in the DJIA on a single day and widespread fear and uncertainty ensued. It was panic indeed as investors pulled $144 billion from U.S. money funds in just two days following the Lehman collapse. Banks, in turn, were afraid to lend, and this fear paralyzed credit markets, further deepening the crisis.
  • COVID-19 Pandemic (2020): In early 2020, the COVID-19 pandemic triggered an enormous sell-off in global stock markets. In 23 trading days, the S&P 500 fell 34%. The CBOE Volatility Index (VIX), the most widely known “fear gauge,” hit a record high of 82.69 on March 16, 2020. The sheer level of fear saw unprecedented selling; speculators dumped holdings to move to the sidelines of the market in cash or other safe-haven assets.

Behavioral Responses:

  • Dealing With Panic Selling — When the markets crash, many investors practice panic selling, where they try to get out of assets as fast as possible to cut further losses. This was especially evident during the 2008 financial crisis when the DJIA experienced a greater than 50% loss as investors exited. Many investors who panic sell have realized actual losses that could have been turned around if they had held on to their positions.
  • Copy-Cat Behavior: Investors tend to mimic what others are doing, known as herd mentality. The dot-com bubble burst in 2000 as nervous investors cashed in their tech stocks, driven by the fact that other investors were doing the same, which exacerbated the downturn. This can encourage craziness, concentrating herding market hoards and further destabilizing financial markets.
  • Risk Aversion: After a market crash, investors are much more likely to be risk-averse and allocate towards more prudent investments. Increasing allocations to bonds and other fixed-income securities also took place following the financial crisis of 2008. This move would mean that more money is invested into workspaces, and therefore, capital is taken away from stock markets, making recovery less coupled to stock markets.

Effects on Psychological and Group-Based Basis:

  • Retail Investors: Individuals who are not always equipped with resources and the know-how to manage their portfolios effectively when the market is crashing. This panic and stress cause people to make mistakes and sell at the bottom of the market. Many retail investors sold during the COVID-19 crash and later missed the recovery.
  • Institutional Investors: Institutional investors’ psychological pressures are more susceptible to network changes, notwithstanding their more mature strategies. High expectations can lead to stories being manipulated for clickbait. Many well-seasoned hedge fund investors still had to be liquidated in 2008 as anyone who was to experience pain did.

Coping Mechanisms and Solutions:

  • Information: Maintaining and sharing the right information before time can help investors make the right decisions. If you were familiar with government interventions and market conditions in 2008, you were probably able to navigate your way through the crisis and adjust your portfolio accordingly.
  • The Long-term View — Looking at investment in the long term and thinking forward might reduce some of the psychological effects of market volatility. Those who stuck to their guns, riding out the virus crash of 2020 on a long-term level, watched their portfolios recover as markets rebounded.
  • Diversification — Having a well-diversified portfolio can soften the blow of a market drop as it impacts more than just one (or a few) investment(s). This strategy reduces exposure to risk and keeps it stable during volatile periods.
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