What Is A Stock Market Crash?

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Stock market crash is a sharp and unexpected decline of stock market prices for a very short period of time, usually accompanied with the decline of many other assets’ prices. As a result, the most of the investors and speculators in the market realize significant capital losses. The losses themselves cause panic and fear among market participants, this deepens the contraction and causes more losses, they cause more panic, etc. This way a stock market crash is usually a self reinforcing process that is totally uncontrollable.

The crash of the Dow Jones index in 2007

The crash of the Dow Jones index in 2007

Stock market crashes are social events caused by both, economic conditions and human behavior. Usually a crash happens when economic participants have far from reality perceptions and assessment of the situation, which usually cause stock market bubbles. It is not that easy to define the “far from reality” situation, though. There are no clear, objective and specific reasons for crashes and that’s why they are hardly predictable. But when they happen, they are clearly recognizable by a sharp and steep decline of market prices for a very short period of time caused by panic and fear.

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Market crashes are not only harmful for stock market participants, but they also affect the whole society causing economic crises. Usually a crash is followed by a depression or a recession, which cause higher unemployment, bankruptcies, bank failures, falling prices and lower living standards.

Crashes and crises are the big flaws of capitalism. Even the modern economic science is not able to stop and fully explain economic crises. This rises some serious questions about the degree at which the theories are applicable to the real world. According to free market theory (the backbone of modern capitalism) the market have to correct itself automatically, if it is not in equilibrium. This way a crisis would be avoided, but this doesn’t seem to work in reality. Not only the market doesn’t correct itself, but also the contraction could self reinforce itself. This is what has been happening for the last several years, since mortgage crisis began in 2007. A proof for this are also many other economic crashes happening every several years.

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A major conception explaining stock market crashes and economic crises is George Soros’ Reflexivity theory, which I find the most relevant one. I am highly influenced by his work and will try to explain some of the major crashes using Soros’ arsenal of knowledge. Read more about this great investor here, and about his Reflexivity theory here.