Investors are constantly analyzing different markets to invest in that exhibit the greatest amount of return with the least amount of risk.
Traditionally, the higher the risk with the investment the higher the return. While all investments carry inherent risk, some investments are riskier by nature. Fortunately, every market carries risk differently.
For example, in real estate, an investor can select a risky fixer-upper while another investor can pick a less risky apartment complex to invest in.
This is the exact same concept for all markets, including the stock market. Just like with real estate, there are times of extreme volatility and heightened risk in the stock market.
Volatility is very much a part of the cyclical nature of markets. This means that there are times that stock prices are high and others when stock prices are low.
The first step to settling anxieties around the stock market is to better understand what exactly the stock market is.
The stock market is composed of thousands of individual stocks from around the world. Oftentimes the term stock exchange and stock market are used interchangeably. However, these two terms do not have the same meaning.
A stock exchange is the entity by which stocks are purchased and sold. Within the United States there are numerous stock exchanges. Two of the largest U.S. stock exchanges are the Nasdaq and the New York Stock Exchange (NYSE).
The stock market is comprised of stock exchanges from around the world. Some additional examples of large stock exchanges from around the world are the Tokyo Stock Exchange (TSE), Shanghai Stock Exchange (SSE), and Euronext.
All stock exchanges have specific rules and regulations depending on their location of business.
The stock exchanges in the United States are regulated by the Securities and Exchange Commission (SEC) as well as other local regulatory entities. The SEC was created to protect investors and to protect the securities markets.
One of the most familiar rules that the SEC created is that publicly traded companies (those listed on U.S. stock exchanges) must provide periodic financial reports to the public. This enables fair trading and protects investors from fraudulent activities.
Violators to the SEC rules are subject to negative legal ramifications.
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Unfortunately the rules and regulations of the stock market don’t remove all investment risks.
A healthy mix of gains and losses are a normal part of the stock market. The overall performance of the stock market is determined by the thousands of underlying stocks in the market. When the stocks rise, so does the stock market.
Remember that a stock is a security that represents a fractional piece of a corporation. As the owner of the stock, you are a partial owner of the corporation (albeit a very small owner).
In a perfect world, the stock price is an exact representation of the true value of a company. When a company goes through the process of valuation to list on a stock exchange, that is an important piece of the initial public offering (IPO).
During the IPO process, the company will work with investment banks to receive an appropriate valuation. The value of the company is determined by the stock price multiplied by the total number of shares outstanding. The investment banks help influence these two numbers.
To successfully value the company, the investment banks gather all the information that they can about the company. Then after analyzing aspects like the financial potential, operational potential, and demand of the stock, the shares are then sold.
Typically, this first round of sales is limited to large investors and institutions. After this initial offering though, the shares become available to the average investor. From this point on, the stock price will have a lot of fluctuations in price.
First, there are millions of investors in the world. Each of these investors have their own criteria to value a company. As such, one investor may believe a company is undervalued because the financial reports show that the company is experiencing great financial success. This investor then wants to buy the stock.
Another investor may look at that exact same financial report and determine that while the company is experiencing great financial success, the company is currently overvalued. This investor then wants to sell the stock.
The value of the company differs from investor to investor. In essence, the value of a company is only what society deems it to be. The stock market is an efficient entity to help balance the supply and demand for the company stock.
Second, other external factors outside of a company’s control can influence the stock price. For example, in 2020 the world was hit with the COVID-19 Pandemic. As a result, stock prices of the majority of companies plummeted. This was at no fault to the individual companies but investor fear of the future led to a sharp sell off of shares causing the prices to decrease.
The greatest investors have utilized experiences from the past to inform decisions for the future. It is beneficial to explore the greatest stock market crashes of all time to see how the overall stock market was impacted during these time frames.
Check out a full analysis on the below stock market crashes.
To this day, the 1929 stock market crash is known as the greatest stock market crash of all time.
After just two days had passed to start the year of 1929, the Dow Jones (stock market index of 30 prominent companies listed on stock exchanges in the United States) plummeted 25%. After a little over two weeks, the Dow had continued to stumble resulting in around a 50% decrease in value. Since the Dow does not represent all stocks in the stock market, the overall stock market was down 20% at this time. By 1932 the Dow was down a whopping 89% from its previous all-time high.
It took until 1954 for prices in the Dow to return to its pre-crash value.
On a Monday in October of 1987, the Dow experienced its single greatest day of declines at nearly -22% on the day. By the end of October the majority of the major stock market indexes were down 20%.
In November of 1987, the Dow began a rebound and by September of 1989, the Dow returned to its pre-crash value.
In just five years, the Nasdaq had risen over 5x in value. However, by early 2001, the tech bubble began to burst leading to a decrease in Nasdaq value. By the end of 2002 the Nasdaq had fallen over 76% from its high.
The Nasdaq returned to its pre-crash value 15 years later.
In September of 2008 all major stock indexes had lost about 20% of their value. The Dow did not reach its lowest point until the beginning of 2009 at a loss of 54%.
Four years following this crash, the Dow returned to its pre-crash value.
In February of 2020 the Dow and S&P 500 (500 leading stocks in the U.S.) dropped over 10% in a week. The Dow declined almost 10% in March, representing the greatest single-day drop since the 1987 crash. The Dow then went on to drop an additional 13% a few days later.
However, unlike crashes in the past, the stock market rebounded just a couple months later. This rebound was largely due to government intervention where the previous crashes did not receive the same government stimulus and support from the Federal Reserve.
In every example above, the stock market experienced extreme volatility and many investors lost massive amounts of money.
While each crash was unique and had various causes, there are consistencies that can be pulled from each experience.
First, the stock market never went to zero in any of the biggest U.S. crashes. Although there was extreme volatility and loss of gains, the market never bottomed out.
Second, some major indexes were impacted more than others. As a simple example, the 2001 stock market crash heavily impacted indexes that held tech stocks. As an index had more tech stocks, it was impacted more heavily. However, in totality the general stock market did not fall as hard as those tech indexes because the entire market is diversified.
Lastly, the stock market has always returned to pre-crash values. Some crashes have returned extremely quickly (2020 crash), while others have taken a long period of time (1929). However, there has always been a rebound.
In conclusion, volatility in the stock market is normal! In order for the entire stock market to hit zero, all publicly traded companies would practically have to become worthless in the eyes of society. If this ever happens, there are bigger problems in the world than the stock market.
Rest assured that history has shown that even during the worst economic downturns, the stock market has not hit zero!