Did you know that in 1929, more than $30 billion was wiped out from the U.S. stock market in just four days? Or that in 2008, more than $10 trillion was lost from global stock markets in less than a year? These are just some examples of how financial crises can wreak havoc on investors’ wealth and well-being.
Financial crises are periods of severe disruption in financial markets that are characterized by sharp declines in asset prices, widespread panic among investors, and often systemic failures of financial institutions. They can have devastating effects on the economy, society, and individual investors, such as unemployment, poverty, inequality, and loss of wealth.
But what causes financial crises? And how can investors avoid or mitigate their impact? In this article, we will explore two of the most notorious financial crises in history: the 1929 stock market crash and the 2008 global financial crisis. We will examine their causes, events, magnitude, and aftermath. We will also analyze how investors failed during these periods, and what lessons they learned for the future.
Key Takeaways
- Excessive speculation, lax regulation, risky lending, and irrational exuberance are some of the common factors that trigger financial crises.
- Financial crises can cause severe damage to the economy, society, and individual investors, such as unemployment, poverty, inequality, and loss of wealth.
- Financial crises can also offer opportunities for learning, reform, and innovation, such as new regulations, policies, technologies, and strategies.
- Investors can protect themselves from financial crises by diversifying their portfolio, doing their research, being cautious, and seeking professional advice.
The 1929 Stock Market Crash and the Great Depression
The 1929 stock market crash was one of the most catastrophic events in financial history. It marked the end of the Roaring Twenties, a decade of rapid economic growth, technological innovation, and social change in the U.S. It also ushered in the Great Depression, a prolonged period of economic stagnation, deflation, and misery that lasted until the late 1930s.
What Happened?
The 1929 stock market crash was triggered by a combination of factors, such as:
- Excessive speculation: Many investors were lured by the promise of easy profits in the stock market, which had been rising steadily since 1921. They bought stocks on margin, meaning they borrowed money from brokers to buy more stocks than they could afford. They hoped to sell them at a higher price and repay their loans with interest. This created a positive feedback loop that inflated stock prices beyond their fundamental value.
- Lax regulation: The U.S. government and the Federal Reserve did little to prevent or curb the speculative frenzy in the stock market. They believed that the market was self-regulating and that intervention would hamper economic growth. They also failed to monitor or control the activities of banks and brokers, who engaged in risky and fraudulent practices, such as lending too much money to margin buyers, manipulating stock prices, and creating pools and trusts to corner the market.
- Risky lending: The U.S. economy was also fueled by a credit boom, as banks and other financial institutions lent money to consumers and businesses for various purposes, such as buying cars, houses, appliances, and stocks. However, many of these loans were based on shaky collateral or unrealistic expectations of future income. As a result, many borrowers defaulted on their loans when the economy slowed down or interest rates rose.
- Irrational exuberance: The U.S. public was also swept by a wave of optimism and confidence in the future of the economy and the stock market. They believed that the U.S. was entering a new era of prosperity and progress, and that stock prices would continue to rise indefinitely. They ignored or dismissed the signs of trouble, such as declining industrial production, falling farm incomes, rising consumer debt, and widening income inequality.
The 1929 stock market crash occurred in two phases:
- The first phase was on October 24, 1929, also known as Black Thursday. On that day, the Dow Jones Industrial Average (DJIA), a major stock index, dropped by 11% in a matter of hours. This was due to a sudden surge of selling pressure from margin buyers who received margin calls from their brokers, meaning they had to either deposit more money or sell their stocks to cover their loans. The selling panic was exacerbated by rumors of bank failures, broker bankruptcies, and pool liquidations. The market was temporarily stabilized by a group of bankers who injected liquidity into the market and bought stocks at above-market prices.
- The second phase was on October 29, 1929, also known as Black Tuesday. On that day, the DJIA plunged by another 12%, as more margin buyers were forced to sell their stocks at any price. The market was also flooded by selling orders from investors who had lost faith in the market or needed cash for other purposes. The volume of trading was so high that the ticker tape, which reported stock prices, lagged behind by several hours. The market closed at its lowest point since 1921.
The 1929 stock market crash wiped out more than $30 billion from the U.S. stock market in just four days1. This was equivalent to about 30% of the U.S. gross domestic product (GDP) at that time2. The crash also triggered a domino effect that spread across other financial markets and sectors of the economy.
What Were the Effects?
The effects of the 1929 stock market crash and the subsequent Great Depression were devastating for the economy, society, and investors, such as:
- Economic contraction: The U.S. economy contracted by about 27% from 1929 to 19333. This was due to a vicious cycle of falling demand, production, income, and employment. As consumers and businesses lost money and confidence, they reduced their spending and investment, which led to lower profits and revenues for firms, which led to lower wages and layoffs for workers, which led to lower income and consumption for households, and so on.
- Deflation: The U.S. economy also experienced deflation, or a general decline in prices, during the Great Depression. The consumer price index (CPI), a measure of inflation, fell by about 25% from 1929 to 19334. This was due to a combination of factors, such as excess supply, reduced demand, lower production costs, and monetary contraction. Deflation worsened the economic situation by increasing the real value of debt and discouraging spending and borrowing
- Unemployment: The U.S. economy also suffered from massive unemployment during the Great Depression. The unemployment rate, which measures the percentage of the labor force that is jobless, rose from about 3% in 1929 to about 25% in 1933. This meant that about 15 million people were out of work at the peak of the depression. Unemployment was especially high among certain groups, such as farmers, minorities, immigrants, and young people.
- Poverty: The U.S. economy also witnessed a rise in poverty and inequality during the Great Depression. The poverty rate, which measures the percentage of the population that lives below a certain income threshold, increased from about 12% in 1929 to about 33% in 1933. This meant that about 40 million people were living in poverty at the peak of the depression. Poverty was also unevenly distributed across regions, races, and genders.
- Social unrest: The U.S. society also experienced social unrest and turmoil during the Great Depression. Many people protested, rioted, or went on strike to demand relief, reform, or revolution. Some examples of social movements that emerged or intensified during this period are the Bonus Army, the Dust Bowl migrants, the labor unions, the Communist Party, and the Ku Klux Klan. Some people also resorted to crime, violence, or suicide to cope with their hardships.
- Loss of confidence: The U.S. investors also suffered from a loss of confidence and trust in the financial system and the government during the Great Depression. Many investors lost their savings, pensions, or investments in the stock market crash or bank failures. Many investors also became disillusioned with the policies and actions of the Federal Reserve, the Treasury Department, and the President. Many investors also became skeptical or cynical about the future of the economy and the stock market.
What Were the Mistakes and Failures of Investors?
The 1929 stock market crash and the Great Depression exposed many mistakes and failures of investors during this period, such as:
- Overconfidence: Many investors were overconfident in their ability to predict or beat the market. They believed that they had superior information, skills, or strategies that would guarantee them profits. They ignored or dismissed the risks, uncertainties, or limitations of their investments. They also relied too much on past performance or trends to guide their decisions.
- Herd mentality: Many investors were influenced by the behavior or opinions of other investors. They followed the crowd or copied what others were doing without thinking for themselves. They succumbed to peer pressure or social proof to buy or sell stocks. They also suffered from confirmation bias or groupthink to reinforce their beliefs or choices.
- Leverage: Many investors used leverage to amplify their returns or losses. They borrowed money from brokers, banks, or other sources to buy more stocks than they could afford. They hoped to repay their loans with interest from their profits. However, when the market turned against them, they faced margin calls or liquidation that forced them to sell their stocks at a loss.
- Margin trading: Many investors engaged in margin trading, which is a form of leverage that involves buying stocks with borrowed money from brokers. They only had to pay a fraction of the stock price as a down payment, or margin, and borrow the rest from their brokers. They hoped to sell their stocks at a higher price and repay their loans with interest. However, when the market fell, they faced margin calls from their brokers, meaning they had to either deposit more money or sell their stocks to cover their loans.
- Lack of diversification: Many investors lacked diversification in their portfolio, which is a strategy that involves spreading one’s investments across different asset classes, sectors, or regions to reduce risk and volatility. They put all their eggs in one basket, or invested too heavily in one type of asset, such as stocks, or one sector, such as technology, or one region, such as the U.S. They failed to hedge their bets or balance their exposure to different sources of risk and return.
The table below compares the performance of different asset classes before and after the 1929 stock market crash:
| Asset Class | Annualized Return (1921-1929) | Annualized Return (1929-1932) |
|---|---|---|
| Stocks | 19.8% | -31.5% |
| Bonds | 4.6% | 4.4% |
| Cash | 3.7% | 1.6% |
| Gold | -3.2% | -2% |
As you can see, stocks outperformed other asset classes during the boom period, but underperformed during the bust period. Bonds and cash provided stable returns and preserved capital during both periods. Gold performed poorly during both periods, as it was fixed to the U.S. dollar and subject to government controls.