Will the stock market crash?

A stock market crash occurs when there is a dramatic and swift decline in stock prices across many sectors or industries. This decline happens quickly in just a few days or can take some time to hit the bottom, so to say. 

This drop is so significant that the stock markets end up closing early in order to prevent the stock prices from declining even further.

A stock market correction should not be confused with a crash. A correction takes place when the market has been overvalued and needs to be adjusted by coming down to its respective valuation. 

Market corrections happen often and usually don't last very long, because when they have been readjusted, it’s back to business as usual.

A crash, however, is when all hell breaks loose and the sky is falling. You'll hear newscasters preaching the end of the world and you'll see politicians blame one another's policies that led to the crash.

A stock market crash can be influenced by many events: like an economic depression or recession, instability in countries and stockholders' speculations bidding up shares so much that they form stock market bubble.

This is purely emotional and all logic is out of the window. The bubble always ends up bursting and shareholders start selling in panic. When this happens, you need to stay calm of course; if you panic you will make mistakes.

The first thing to remember is that we've had crashes before in the past. Each one has always been different, but we've been able to bounce back.

If you are a short-term investor then this is the right time to start short selling, which is the act of borrowing shares, selling them at the higher market price, than buying them back at a lower market price and finally returning those borrowed shares, the difference is your profit.

If you're retired or close to retirement, your money needs to be in safer fixed-income assets, so you should not feel too much of the sting. I'm talking about assets like bonds, cash, money market accounts, savings accounts and annuities.

Only a small percentage needs to be in stocks. If you are a long-term investor, continue to stick to your investing strategy of consistently buying investments weekly, bi-weekly or even monthly.

What you are doing is called dollar cost averaging. This is when you invest a fixed dollar amount periodically to buy investments. If you are investing through your employer in the 401k, then you are already participating in dollar cost averaging, because money that is taken out of your check is invested on a weekly, bi-weekly or monthly basis no matter what is happening in the market.

The benefit of this is that it takes out your emotions, because your money is invested during the good times and the bad. So, you're buying investments when they are both expensive and cheap, which averages you out.

The biggest advantage to invest during a market crash is that you can buy stocks really cheap. It's like going through your local store and you see everything is on sale for at least 40% off. So, those new black shoes you wanted are now 60% off. The new MacBook you're looking to buy … 50% off.

I know most people don't have the stomach to buy during a crash this is when dollar cost averaging is your much-needed friend. Allowing you to buy equities while they are cheap also boost your compound interest which is the interest you've received on your original investment amount, which is compounded with the latest interest just received.

So, in other words, you're making interest on your interest.

While everyone around you is panic selling at a loss and losing their investments, you're calmly buying more assets through dollar cost averaging and undervalued individual stocks at an affordable price and holding on to them for the long term.

On a side note, make sure you hold on to your dividend paying stocks, because these companies are mostly well-established market leaders. When there is a crash they tend to bounce back quicker compared to non-dividend paying stocks, like most tech companies.

The dividend you receive from these companies also acts like a cushion to lessen the blow from the crash; companies like McDonald's, Pepsi and Nike continued to pay dividends even during the housing crash of 2008-09.

Let's look at two examples of stock market crashes. The first example is the crash of 1929 that led to the Great Depression. Different bankers, investment firms and traders participated in manipulating the markets by buying large chunks of highly overvalued stocks and then selling these to unsuspected retail investors. Investors like you and me.

Because these businesses bought a large number of shares, they were constantly pushing up the share prices. Individual investors saw their share prices skyrocket and kept purchasing more, because there was no limit, they thought.

They even opened margin accounts letting them invest with borrowed money, offered by their brokerage firms. Most institutional investors did reap their rewards and jumped out of the market leaving the individual investors with overpriced stocks.

When the decline happened, everything went fast. Not only did people lose money, because they got hit with the margin call to return the money they borrowed, they also lost their jobs, their retirement wealth (which was of course invested in the stock market), and many people lost their minds.

The second crash we will take a look at is the dotcom crash of the early 2000s. The dotcom bubble was based purely on speculation. The internet was that new shiny object everybody wanted a piece off. Everybody and their Grandma tried setting up a website and then trading it on the secondary market through an IPO.

Many of these companies never could make a profit or were mostly in the red, but people did not care, websites where evaluated by how many clicks they received or how many eyeballs they could generate, instead of using traditional valuation methods, like revenue and expenses.

At the height of the bubble everything came tumbling down, like a house of cards. Many startup companies received millions in venture capital funds with the impossible task to get just as big if not bigger than the tech giants of those days like Microsoft, Apple and Oracle.