What Happens When Stock Market Crashes? There is no gentle way to put it. In the blink of an eye, the March 2020 stock market crash erased an extraordinary amount of wealth.
The first sign of trouble was a shocking drop on March 9th, during which the Dow Jones Industrial Average fell by 2,013.76 points to close at 23,851.02. The decline continued on March 12th, with a loss of 2,352.60 points, and the DJIA closed at 21,200.62.
The dramatic selloff was primarily driven by fears related to the coronavirus/COVID-19 pandemic. As a result, trillions of dollars simply vanished. Companies are laying off workers and governments around the world are scrambling to find solutions that will prevent long-term economic damage. It’s no wonder many investors are feeling a bit frantic.
The good news – and there is good news – is this: long-term, the stock market has always returned value. There is no reason to believe this time will be any different.
The best thing you can do in this situation is not to panic and sell off quality stocks at a substantial loss. Instead, take a closer look at some of the investments that tend to do well during market downturns and consider this an opportunity to diversify further.
These are six of the outcomes you can expect when the stock market crashes:
Stocks Fall in Value
Obviously, stocks fall in value when the stock market crashes, but there is a silver lining to this cloud. Now is the time to round out your portfolio with shares of top-quality companies at bargain rates.
Short-term, there are sure to be ups and downs while the market works through the current crisis, but there is every reason to believe these companies will deliver value over time.
Volatility [VIX] Rises in Price
When stocks fall in value – particularly when the drop is sudden and dramatic – volatility tends to rise.
The term volatility refers to the range of changes in stock value, and it may be used as a measure of individual shares, a particular index, or the market as a whole.
As a general rule, high levels of volatility represent riskier investments, and the more volatile the market is, the more likely it is to be heading in a downward trajectory.
Smart investors can benefit from a volatile market through careful attention to the Chicago Board Options Exchange’s Volatility Index (VIX). This index quantifies how investors are feeling about the market, which tends to play a major role in actual market movement.
Essentially, it looks at call and put options. These are contracts that give investors the right, but not the obligation, to buy or sell specific securities at an agreed-upon price. By measuring activity in options contracts, the VIX strives to calculate investor expectations for the coming 30-day period.
Some investors use the VIX to make decisions about how to invest, while others invest in volatility indexes directly. Examples of VIX investment opportunities include ProShares VIX Short-Term Futures ETF (VIXY), ProShares VIX Mid-Term Futures ETF (VIXM), and the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX).
Put Options Increase in Value
Speaking of options, those holding put options are in an excellent position to profit from a stock market crash. These are the contracts that give investors the right, though not the obligation, to sell a specified security at a predetermined price. Put options are time-bound, so holders can sell the underlying securities until the contract expires.
Consider this scenario: you hold a put option for 100 shares of XYZ at a strike price of $20 per share. When you bought the option, shares were trading at $22 per share, making your option worthless.
However, after the stock market crashes, shares of XYZ are valued at $10. Since you can sell at $20 per share, you have an opportunity to walk away with profits of $10 per share.
Note that put options are available for all sorts of assets, including stocks, bonds, indexes, commodities, futures, and currencies.
Companies May Cut Dividends
Sudden loss of value has most companies looking at all possible ways to conserve cash. Dividend payments are on the table, and it is likely that many companies will have to make the difficult decision to reduce or eliminate payments.
Rest assured that this is typically considered a last resort, and most companies will make every effort to avoid such drastic measures.
Nonetheless, if you rely on dividend income, it’s smart to ensure you have a backup plan for continued income if some of your dividend payments are interrupted.
Hedge Funds Usually Outperform
Hedge funds are particularly tricky investments, and they are typically reserved for experienced, high net-worth investors. At their most basic, they look a bit like mutual funds, but hedge fund managers use much more complex and aggressive investment tactics in an attempt to generate returns.
As the name suggests, hedge fund managers are focused on generating profits whether the market goes up or down. Through a variety of maneuvers, the fund is positioned to profit from both highs and lows.
As a result, these funds tend to do quite well in a stock market crash, because they are some of the few that are set up to profit from market losses.
Bonds Usually Rise In Price
Many portfolios balance risk by offsetting stocks with bonds. The strategy behind this has to do with the fact that bonds are less likely to lose principal. When you purchase a bond, you are making a loan to the seller, who promises to pay back the full amount plus interest when the bond matures.
A stock market crash signifies that investors have lost confidence in the market, and they tend to move money into less-risky bonds for the duration of the crisis. High demand for bonds means people will buy at lower interest rates. That drives up the price of existing bonds with higher interest rates. For those with well-diversified portfolios that include bonds, this is good news. The increased value of the bonds can offset some of the stock losses.
The bottom line is that a stock market crash is deeply unsettling. Some feel that it is simply not possible to recover from the losses. The truth is that a sudden market downturn can mean serious financial pressure – sometimes for months or years – but there are opportunities to create positive results even when the economy seems bleak. In short, don’t panic. Make thoughtful, deliberate investment decisions to preserve and grow your wealth.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.