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Global stock markets have tumbled in recent days, as economic warning signs shook the US and the rest of the world felt the reverberations.
The Australian Securities Exchange fell almost 4% on Monday 5 August.
With the outlook remaining uncertain, investors may be wondering how best to protect their investments in the event of a stock market crash.
Here’s a look at what triggers such a collapse, what’s happened in the aftermath of previous large crashes, the outlook for shares generally, and how investors can protect their portfolios.
Related: How does inflation affect stocks?
What is the cause of recent market volatility?
On Friday, US government figures showed employment has risen to a three-year high of 4.3%. Meanwhile, disappointing earnings from major US tech companies triggered a bout of stock sell-offs. This was amplified by the willingness of tech stock investors to cream off some of the profits they have built up of late in artificial intelligence-oriented companies.
In response to this economic turbulence, the Nasdaq composite index, which comprises roughly 55% tech companies, fell 2.43% on Friday, while the S&P 500 fell 1.84%.
The impact has been far-reaching, with Japan being perhaps worst affected. Shares in the country’s semiconductor companies, which supply many of the US tech giants with electrical components, plummeted in value on Monday 5 August.
On top of this, the Bank of Japan – the country’s central bank – made a surprise move to raise interest rates last week, while the US Federal Reserve is widely expected to cut rates in the coming months in a bid to stave off the looming threat of recession in 2025.
As a result, the Japanese yen has risen in value against the dollar, making the prospect of investing in Japanese shares less appealing to US investors. A strong yen also makes life tough for the cuntry’s exporters, whose goods cost more for overseas buyers.
On Monday, Japan’s Nikkei index experienced its worst trading day since 1987, plummeting 12.4% as global investors sold off Japanese holdings.
European and UK markets did not escaped the global fallout The Stoxx Europe 600 index, a benchmark for the region, dropped 2.5% on Monday, while in London the FTSE 100 fell by over 3% at one point in the day.
Russ Mould, investment director at AJ Bell, says: “The question now is whether this is just a tempest in a teapot or whether it is the harbinger of a more serious – and bearish – shift in market sentiment.”
Despite this current volatility, investors can take steps to protect the value of their portfolios in the long-term, however.
Lindsay James, investment strategist at Quilter Investments, said: “Ultimately this period of outsized volatility against what remains a reasonably solid economic backdrop should present a buying opportunity for long-term investors.
“This can be a great time to take advantage of a better entry point with globally diversified, multi-asset portfolios.”
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What Is a Stock Market Crash?
A stock market crash refers to a rapid, often unexpected, fall in share prices. Typically, this is defined as a drop of at least 10% on a stock exchange or major index in a day, or over a few days.
A stock market crash may be temporary, with prices recovering in days or weeks. However, a crash can also signal the start of a longer downturn that can last for months, or even years.
Major stock market crashes in living memory include Black Monday (1987), the bursting of the dot.com bubble (2001-2002), the global financial crisis (2008-2009), and the Covid-19 pandemic (2020).
The infamous Wall Street crash of October 1929 plunged the US into the so-called Great Depression lasting several years.
What Causes a Stock Market Crash?
A crash typically occurs at the end of a bull market, where share prices have risen for several years, and investors start to question whether companies have become overvalued.
If investors start to sell shares as they believe share prices are unrealistic and will fall, this can trigger wide-scale panic selling. This creates a downward spiral of further share price falls as investors lose confidence in holding shares and hit the sell button.
Macro-economic factors can also play a role in triggering stock market crashes. In Australia in late 2022, inflation was at its highest level in more than 20 years, which led to central banks increasing interest rates to curb inflation.
Rising interest rates tend to have a negative impact on stock markets for the following reasons:
- Valuations of ‘growth’ stocks: higher interest rates reduce the valuations of growth stocks, such as US technology firms, by decreasing the current value of future cash flows.
- Reduced consumer spending: companies may face reduced demand from consumers with less money to spend if the cost of debt increases, along with a rise in the cost of everyday items due to inflation.
- Relative return on savings: higher interest rates may encourage investors to move out of shares into cash-based products.
Related: Best Investments to Beat Inflation
Previous Stock Market Crashes
Investors naturally focus on how long stock markets have taken to recover after previous crashes. To provide some insight, the Forbes Advisor team analysed the major stock market crashes in the UK’s FTSE 100 between 2000 and 2022.
Source of historical FTSE 100 data: WSJ Markets
While this data refers to London’s stock exchange, Australian investors can glean insights from some of the trends.
First, that the stock market is naturally cyclical, with, in the case of the FTSE, major falls of around 20% to 50% every eight to 10 years on average.
Unsurprisingly, the stock market has taken longer to recover from steeper falls, taking over four years to rebound from the 50% fall during the crashes caused by the dot.com bubble and the global financial crisis.
That said, more recent stock market falls have been shorter-lived, with the FTSE 100 recovering its pandemic losses within two years and within less than a year for the dip in 2015-2016.
Vanguard publishes an annual Index Chart showing market returns per year over the past 30 years. The most recent report for 2023 found that while Australian shares were down 7.4% in 2022, they back in black the following year, posting a 14.8% return.
It was a similar story in the US, with shares dropping 6.5% in 2022 before rebounding to 22.6% in 2023.
As Vanguard notes, it’s time in the market, not timing the market that matters.
“A $10,000 investment in the Australian share market over (30 years), when measured by the S&P/ASX All Ordinaries Total Return Index, would have increased to $138,778 based on the same strategy of reinvesting all the income distributions,” the report states.
“That represents a 9.2% per annum average annual return over the 30-year period, and a total compound return of more than 1,280%.”
Should Investors ‘Buy on the Dip’ or ‘Sell in the Fall’?
It may be tempting to try to sell investments before a crash and buy them back at lower prices just before the rebound.
But, in reality, ‘buying on the dip’ is difficult to time, even for professional investors, with one trader advising Australian investors to give up the mantra entirely.
“I think all of us need to unlearn the ‘buy the dip’ mentality as that is a dangerous proposition in a falling market environment,” chief strategy officer of Tiger Brokers, Michael McCarthy, told ABC news.
While many investors may point to the gains they made under a ‘buying the dip’ strategy during the Covid-19 crash of March 2020, we are in a very different monetary policy environment in 2024: central banks are no longer pumping trillions of dollars into the economy and most have raised interest rates to take the heat out of the economy.
Russ Mould, investment director at AJ Bell, says history would suggest caution is needed when trying to beat the market: “No fewer than nine major rallies produced an average gain of 23% during technology stocks’ last major fall [in the global financial crisis] and all they did was expose buyers to a fresh mauling from a bear market as the Nasdaq plunged by 78%.”
Overall, investors taking a long-term view, rather than trying to ‘beat the market’, are able to smooth out their average returns.
Over a 30-year period, Australian shares have averaged a return of 10%, according to Vanguard.
How to protect against a stock market crash
Although stock market dips are a normal feature of equity markets, that doesn’t mean you can’t prepare for them. Consider some of the following steps to protect your portfolios against a downturn:
(i) Diversify into Different Sectors and Countries
Collective investment products such as funds and investment trusts offer a ready-made, diversified portfolio of share-based assets. This is a lower-risk option than investing directly in individual companies.
Buying funds or ETFs covering different geographic or industry sectors will reduce volatility and the risk of one or more sectors underperforming. Legendary investor Sir John Templeton extolled the virtue of diversification, saying that “The only investors that don’t need to diversify are those that are right 100% of the time.”
As finance expert Tony Featherstone states in ASX Investor Update: “Income investing is about more than yield. It’s also about managing risk by building and maintaining a diversified portfolio across asset classes. This is especially important for older investors, such as retirees, who want income and capital stability.”
(ii) Diversify into Different Assets
Which brings us to diversification into non-equity-based assets, such as bonds, property and commodities, that may also protect your portfolio in the event of a stock market crash.
It’s important to pick assets that aren’t correlated, in other words, their price movements do not move up and down together, but rise and fall at different times. That way, if one asset falls in value, this should hopefully be offset by other assets holding, or increasing, their value.
If you are looking for a low-cost way to diversify, then there are a number of Exchange-Traded Funds (ETFs) that track the prices and/or indices of certain asset classes, including commodities. Most ETFs in Australia are passive investments, and try to replicate the performance of an index. ETFs track a range of asset classes, including precious metals and commodities, bonds, crypto, foreign currencies, as well as of course local and international shares.
(iii) Time Your Investments
It is very difficult to buy low/sell high when markets are volatile or a crash is imminent. However, there are still steps you can take in terms of timing your investments.
One option is to invest monthly, rather than as a lump-sum, allowing you to benefit from dollar cost averaging. This means that, if stock markets and share prices fall, investors are able to buy more shares or units for the same amount. As a result, investors end up paying the average price across the whole period.
As discussed earlier, investing for the long-term (at least 10 years) helps investors to protect against the impact of stock market crashes.
(iv) Consider Your Super Fund Exposure
The Federal Government’s Moneysmart site, recommends that your choice of superannuation be tailored to your risk appetite, age, and retirement age.
For example, it’s common for Australian workers in their 20s and 30s to opt for growth superannuation funds, with high exposure to shares, because if the stock market crashes they have time to regain the money before they retire.
If you are approaching retirement however, you may opt for a balanced or conservative super fund, as they better protect you from a share market crash. In a conservative fund, it is common for the investment mix to comprise around 30% in shares and property, and 70% in fixed interest and cash. Compare this to a growth fund with around 85% in shares or property, and 15% in fixed interest or cash. A ‘high growth’ option may involve 100% exposure to shares.
As in all cases, speak with your financial advisor to determine the best option for you.
(v) Other Tips for Protecting Your Portfolio
Other potential options for protecting your portfolio against a crash include:
- Stop-loss and limit orders: these allow investors to set a price at which shares are automatically sold. A stop-loss order is an order to sell shares if the price falls to, or below, a set price (the “stop” price). For example, if you bought a share costing 100 pence, and you wanted to limit your downside risk to 10%, you could set a stop-loss order of 90 pence.
- Holding cash: Of course, if you really want to ensure protection from the vagaries of the stock market then you could opt to keep your holdings in cash. Interest rates on the best savings accounts are as high as 5.75%, and are outpacing inflation.
Note: When investing, it’s possible to lose some, and very occasionally all, of your money. Past performance is no prediction of future performance and this article is not intended as a recommendation of any particular asset class, investment strategy or product.
Frequently Asked Questions (FAQs)
How does a sharemarket crash affect the economy?
A stock-market crash can affect the Australian, as well as the global economy in many ways. Naturally, people with shares in the companies listed on the various stock exchanges will see their personal wealth plummet as a result of the crash. Retirees or those approaching retirement are also impacted if their super funds are exposed to the markets. If the crash is deep and sustained then economies can enter either a recession or a depression, which is what occurred in the immediate aftermath of the 1929 stock market crash, plunging the US into a deep depression during the ’30s. Many countries also experienced a recession, a less severe form of a depression, in 2008 in the wake of the global financial crisis (GFC), as national economies heavily contracted. Australia managed to avoid a technical recession during the GFC, which is measured by two periods of negative economic growth. It’s important to remember that not all steep dips in the share price cause recessions and depressions.
What caused the stock market crash of 1929?
The stock market crash of 1929, sometimes called the Great Crash, was preceded by the feverish take up of shares among the US public during the 19020s. It grew to terrific levels and people rushed to get a slice of the market as prices soared. Many people withdrew money from banks in order to pay brokers’ loans for margin accounts; they mortgaged their homes and sold their bonds in order to pour their money into the markets. Some even borrowed money to buy more shares and this started to cause problems when prices began to fall. On October 24, a day universally known as Black Thursday, millions of people rushed to sell their shares amid fears of a falling marker, prompting the market to crash. Some 12.9 million shares were traded on Black Thursday but worse was yet. to come. On the following Black Tuesday more than 16 million shares were traded, and the Dow closed at 198. It would take another 20 years for the Dow to pass the 200-point mark.
Was there a bear market in 2022?
Yes. In 2022 shares in Australia and globally were rocked by high inflation, the start of interest rate hikes, and the threat of recession which led to market sell-offs. According to Vanguard, Australian shares were down 7.4% and 6.5% in the US. Some investors jumped in at this point, a strategy known as ‘buying the dip’, but most experts urge time in the market as the best investment approach.
Can you lose more than you invest?
Yes, you can. If you invest in volatile assets, such as crypto or CFDs, then there is a high chance you could lose more than you invest. The best way to ensure that you don’t lose money—and, in fact, your money compounds, is to invest in solids companies and hold (and reinvest dividends) for the long-term.
