Why Does the Stock Market Crash?
Are We Doomed to Repeat the 2008 Stock Market Crash?
As smoke cleared from the 2008 stock market crash, economists emerged from the wreckage questioning everything they knew. They had believed the stock market was destined for balance, that it tended towards stability, but history showed otherwise.
The conventional view of economics held that investors acted reasonably. These mythical investors would bring stock prices into harmony using their perfect information and flawless logic, bringing order and equilibrium to the market. That’s how economists thought the world worked.
Boy, were they wrong. Shocking as it may seem to the sacred principles of economics, investors, and indeed all people, are not fully rational. They get swept up in emotion, make nonsensical decisions, and treat guesswork as a way of life.
Now, I should be fair. Most economists would be willing to admit that, but they don’t follow through to explain why stock markets crash. They’ll still insist that it was an anomaly caused by this one thing, and it only happened this one time.
But like I said, history tells a different tale. Although the jury is still out on this one, it looks like stock markets may be stuck in a permanent cycle of boom and bust. (Source: “The Minsky Moment,” The New Yorker, February 4, 2008.)
Markets are Great, but Unstable
Most often, stock market crashes are caused by overconfidence. Once economic conditions get too cozy, financial firms get callous about risk and funnel cash into speculative investments. Then comes the groupthink.
The bubble is formed when more and more investors mimic a trend, whether it’s buying technology stock (like in the 2000 crash) or mortgage-backed securities (like in the 2008 crash). When everyone is following the crowd, no one can see where they’re going.
If economists were right about investor behavior, then the due diligence on mortgage-backed securities would have revealed them to be toxic assets. Many of the financial products that had been rated as “AAA” were simply composites of lower-grade assets, yet barely anyone noticed in the run up to the financial crisis.
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