The Mysterious Fall of Stock Prices During Market Crashes

Have you ever wondered why stock prices of all companies plummeted during market crashes, even if the basic principles of supply and demand would suggest otherwise?

Leaning on the Supply and Demand Principle

According to the fundamental supply and demand principle, stock prices are determined by the balance between buyers and sellers in the market. If there are more buyers than sellers, prices rise, and if there are more sellers than buyers, prices fall. This principle forms the bedrock of modern economic theory and practice in the stock market.

The Role of A Game of “The Old Maid”

The stock market operates in a similar manner to the game of "The Old Maid," where players take turns passing a card until the unfortunate player left with the "Old Maid" card loses the game. Similarly, when stock prices start to fall, investors begin to sell off their holdings to avoid ending up with the last remaining stocks, much like getting the "Old Maid" in the game. This creates a glut of supply in the market, pushing down the prices until demand picks up again.

Why Do Stock Prices Fall During Market Crashes?

The reasons for the sudden drop in stock prices during market crashes are complex and multifaceted. A few key factors include:

Psychological and Behavioral Factors

Market crashes are often triggered by sudden shifts in investor sentiment. When markets are going up, buyers (bulls) outnumber sellers (bears), leading to premium prices. Conversely, during a market crash, the sentiment shifts, and sellers (bears) outnumber buyers (bulls), leading to discounts. This phenomenon can be quite dramatic, as investors act on fear and uncertainty, leading to a massive glut of supply.

Liquidity Concerns

In the Indian market, liquidity is an important factor. When foreign institutional investors (FIIs) want to buy a large amount of a stock, they must sometimes pay a premium. However, during market crashes, this dynamic reverses. Investors, particularly large players like institutions and high net worth individuals (HNIs), rush to sell, leading to a glut of supply. The market price thus falls, and the sellers often need to sell at a discount to clear their orders.

A Case Study: Buying into Market Crashes

Consider the example of General Electric (GE). When its stock price drops significantly, it becomes an opportune moment to buy. Analysts recommend buying large quantities of stock on the day when the price reaches an all-time low, such as 1. This is because the low price represents a significant undervaluation, and as the market stabilises and demand picks up, the stock price should rise.

Understanding Why So Many Investors Think Alike

The collective behavior during market crashes can be explained through a simple analogy: shouting "fire" in a crowded theater. When people see or hear that everyone is panicking, they too join in, leading to a rapid exodus. In the stock market, this is often referred to as "bear market syndrome," where the fear of losing money drives investors to sell, creating a domino effect.

It's important to note that while supply and demand principles do play a crucial role, the psychological aspects of market behavior can significantly impact stock prices. Ultimately, choosing fundamentally sound companies can help investors weather market storms and ensure long-term rewards.

Key Takeaways

Market crashes are influenced by both supply and demand principles and psychological factors. During market crashes, the supply of stocks often outweighs demand, leading to a glut and a fall in prices. Fundamental analysis is critical during market downturns to determine the true value of investments.

Keywords: market crash, supply and demand, stock prices