Stock market volatility: friend or foe?

Stock markets are volatile places. Fortunes can be made and lost virtually overnight when sentiment swings for – or against – companies.

There will also be more generalised turbulence. These periods see leading indices rising or falling in response to economic and political events.

Here, we recall some of the most severe stock market movements and how investors should respond to such crises in the future.

Why do stock markets slump?

Fear is the main cause of a stock market crash. For example, people become worried about the impact on their investments of interest rate hikes or the looming prospect of war. Such concerns can cause them to rapidly sell their stock positions to stop the value of their portfolio from plummeting over the coming days and weeks.

The bigger the panic, the larger the index falls. In the most extreme cases, billions of pounds can be wiped from the value of quoted companies within minutes.

So, what has caused some of the biggest stock market falls in history?

1929 stock market crash

This nightmare on Wall Street saw such a sharp decline in US stock market values that it contributed to the Great Depression of the 1930s. The run-up to the crash had seen a growing belief that stock prices would only rise. This resulted in people buying into securities at ever-increasing prices.

However, news about public utility regulation and rising interest rates led to panic selling on so-called Black Thursday (October 24) and Black Tuesday (October 29), according to Goldman Sachs. “Nervous investors liquidated their holdings and the markets plummeted,” it stated. “The Dow Jones index fell to 248.5 units by the end of 1929.”

Black Monday crash in 1987

The 1980s is often regarded as the decade of excess but the Black Monday crash on 19th October 1987 brought the good times to a shuddering halt. This was the date of the single biggest one-day percentage drop in US stock market history, with the Dow Jones Industrial Average plunging by more than 20%*.

The collapse was caused by a number of factors, including computerised stock market trading – still in its infancy at the time – that enabled brokers to implement trades more quickly.

The problems quickly spread to other international markets, causing the FTSE 100 in the UK to suffer its worst one-day loss of 11.4%**.

Bursting of the dot.com bubble

The late 1990s saw enthusiasm for technology stocks spiral out of control. Investors poured money into companies they believed would become the stars of tomorrow.

Even would-be entrepreneurs with only a germ of an idea – and little realistic prospect of turning it into a viable business – saw the value of their companies soar.

Unfortunately, this hype-driven boom period, widely referred to as the dot.com bubble, would come to a dramatic end in 2000. Investors finally woke up to the reality that many of these businesses would never become profitable and the bubble imploded, according to Goldman Sachs. “As the value of tech stocks plummeted, cash-strapped internet start-ups became worthless in months and collapsed,” it stated.

Global financial crisis of 2008

The origins of this financial crisis can be traced back to increased mortgage availability being given to subprime borrowers in the US, effectively those with low credit ratings. This risky borrowing saw people became extremely exposed when US house prices declined as they ended up owing more than their properties were worth. As a result, many defaulted on payments.

Lehman Brothers, which had significant exposure to the subprime market, subsequently collapsed and a period of intense financial turmoil ensued. Over this period, the problems spread around the world with major indices falling on deepening fears of a possible US recession. As an analysis by the Bank of England noted: “The financial crisis revealed how a seemingly isolated issue in one country could have far-reaching consequences.”

Coronavirus of 2020

This stock market crisis was prompted by the global spread of Covid-19, which sent most of the world into lockdown. Uncertainty over how companies and sectors would be affected by the pandemic resulted in indices around the world going into freefall.

The S&P 500 index in the US fell 7.6% in one day on 9 March 2020, according to Schroders. This was its fifth worst trading day since 1988. “On the same day, UK stocks also fell sharply,” it added. “The FTSE All-Share Index dropped 7.4%.” While the crash was severe, it was also relatively short-lived. The following months – and years – saw indices soar again as the world returned to normality.

Responding to turbulence

Unfortunately, there’s no way to completely avoid dramatic stock market falls. By their very nature, they are unpredictable, according to an analysis by Morningstar.

“Not all crashes are alike in their severity and duration, and naming the market’s peak or bottom is tough,” it stated. “Therefore, the best bet is to prepare now for the next crash by owning a well-diversified portfolio that fits one’s time horizon and risk tolerance.”

Remember, your investment decisions should be based on a combination of your overall financial objectives and attitude to risk. Of course, there will be times when virtually all asset classes are affected – as they were in 2022 when rapidly rising inflation and prospect of much higher interest rates caused most assets to fall in value.

On these occasions, you’ll need to decide whether or not to stay in and ride out the volatility. As a general rule, if you don’t need the money, it is best not to crystalise your losses but to wait until markets recover.

It’s also worth remembering that people have made handsome profits in the wake of global problems such as the financial crisis of 2008, according to Schroders. “Such crisis moments attract contrarian investors, such as the feted investor Warren Buffett who invested $5 billion in Goldman Sachs in September 2008,” it stated.

*Source: The Motley Fool
**Source: Reuters, 22 January 2008

_{Photo by Matt Bowden on Unsplash}