Market crashes: what happens, and what to do

What actually happens in a crash

A crash is a period where many people want to sell at once and few want to buy. Prices fall quickly, not because businesses became worthless overnight, but because sellers outnumber buyers and each transaction happens at a lower price than the last.

Several things happen together, and knowing the pattern in advance is genuinely useful when you are inside it.

• Almost everything falls together. Diversification across companies helps far less than usual, because people sell whatever they can rather than what they should.
• Liquidity disappears. Smaller companies become genuinely hard to sell at a sensible price, exactly when people want out.
• The explanations arrive after the fall. Confident accounts of why it happened are written once the fall is already visible.
• Forecasts of further falls multiply. They will be wrong roughly as often as forecasts made in calm periods, which is to say frequently.
• The recovery begins while the news is still bad. Markets do not wait for the situation to resolve, which is why waiting for clarity means missing the turn.

How Indian markets pause a fall

India has a market wide circuit breaker system, introduced by SEBI in 2001 and revised in 2013. It halts trading across all equity and equity derivative markets when either the Nifty 50 or the Sensex moves far enough in either direction.

The limits are calculated daily from the previous close, and trading resumes with a pre-open call auction. The market wide breaker was last triggered on 13 March 2020, and before that in 2008.

Individual stocks have their own price bands, commonly 2%, 5%, 10% or 20%, though stocks with listed derivatives generally do not. If a stock hits its lower band, trading in it effectively stops, which is one specific reason a stop loss can fail to protect you.

Be clear about the purpose. Circuit breakers slow a panic down and give participants time to think. They do not prevent losses, and they can make it impossible to exit at the moment you most want to.

What history shows, stated carefully

Indian markets have been through severe falls repeatedly: the 1992 scam, the 2000 technology collapse, the 2008 global crisis, and the sharp fall of March 2020 when the pandemic arrived.

Two honest observations, and they need to be held together rather than one without the other.

Every fall so far has eventually been recovered by the broad market. Investors who kept holding a diversified position through each of those episodes saw the index reach new highs afterward.

That is history, not a promise, and the recovery took very different lengths of time. March 2020 recovered within about a year. Other episodes took several years. And crucially, individual companies do not follow the index. Plenty of companies that fell in 2008 never recovered, and some no longer exist. "Markets recover" is a statement about diversified indices, not about whatever you happen to own.

What to actually do

One question replaces all the noise: has the business changed, or has only the price changed?

Then the practical steps, in order:

• Do not sell in a panic. Almost every investor who did in past falls regretted it, because they then had to decide when to return, which is the hardest decision in investing.
• Keep the SIP running. This is when a fixed monthly amount buys the most units. It is also when stopping feels most sensible, which is the trap.
• Read your written reasons. For each holding, has the specific reason you recorded stopped being true? That is the test, not the size of the fall.
• Check your emergency fund, not the index. If your job is at risk, cash matters more than any investment decision right now.
• Rebalance if you were going to anyway. After a fall this means buying equity, which feels wrong and is the entire point of having a rule.
• Look at your portfolio less, not more. Increasing attention during a fall increases the chance of acting, and acting is the risk.

Preparing before the next one

Everything that helps during a crash is arranged beforehand. Nothing useful can be built while it is happening.

• An emergency fund that means you are never forced to sell. This is the single most valuable preparation.
• An asset allocation you can genuinely live with. Not the one that looks best in a good year. The one you would hold through a 40% fall.
• Written reasons for every holding. They are the only defence against your own memory during a fall.
• No borrowed money. Leverage removes your ability to wait, which is the only real advantage you have.
• Money needed within three years kept out of equity. Then a crash is an inconvenience rather than an emergency.

A useful way to think about it: a crash does not create the problem, it reveals whichever one you already had. Too much in equity, no cash reserve, positions you never had a reason for, borrowed money. Investors who prepared find falls uncomfortable. Investors who did not find them ruinous, and the difference was decided years earlier.