Why Do Stock Markets Crash?

Between Jan 21st, 2008 and July 6th, 2009, the Sensex witnessed 11 single-day falls of 700+ points. The highest was 1,408.35 points on Jan 21st. In this post, I discuss the simple arguments put forth by Edgar E Peters to understand why such stock market crashes occur, in his book, Fractal Market Analysis.

Kindle version of You Can Be Rich Too NOW only Rs. 87 Grab it now! http://amzn.to/2gJuirE

It is human nature to try and explain the events that occur around us. Unfortunately, it is also human nature to be opinionated and closed-minded.  We conveniently decided to fit stock market returns into a bell curve and temper our risk and return expectations accordingly and proclaimed the markets as “efficient” and “mean reverting”  because the associated math was convenient (if not simple).

Unfortunately, extreme positive returns (bubbles) or extreme negative returns (as above; crashes) cannot be accommodated within the efficient market hypothesis and they became the proverbial elephant in the room, even after 2008 crash.

Our job as investors is to understand risk as best as we can. There is no need for math or fancy formulae. We just need a “feel” for the risk.  To do that, we must get rid of mental baggage (if any) and begin with an open mind.

Who trades in the stock market?

The day trader who seeks profit by the hour or the day. The short-term investor, retail or institution who seeks profit over a week, a month or year. The long-term investors who wish to buy and “hold”.

When are markets stable?

When the day traders dump a security because it is too risky for him to hold, the short-term and long-term investors will step in to buy because it is not a risk in their time-frame. The reverse is also true.  If this process occurs without a blip, there is said to be “enough liquidity” and the market is stable. Sure, it can move up or down by a few points, but nothing dramatic.

When do markets become unstable?

When a short- and long-term investors get scared by a development, they become sellers instead of buyers or holders. Their outlook of the “long-term” has suddenly changed by an unexpected development. Suddenly there is no distinction between a trader and investor. This is results in, what Peters describes as a “free fall” or a stampede.  The notion of a stampede is particularly insightful. A crowd can be managed as long as they do not decide to head for the exit at the same time. Thus, markets become unstable and crash when there is a liquidity crunch. This is what occurred during each of those 11 occasions mentioned above.

Let us not get ahead of ourselves and sound like we are stating a fact. This is a hypothesis – the central idea behind the fractal market hypothesis.

I had introduced the idea of a fractal before.

Fat Tails: The True Nature of Stock Market Returns – Part 1

Fractals: The True Nature of Stock Market Returns – Part 2

The similarity between the returns over minutes, hours, weeks, months and years is referred to as self-similarity. That is the parts appear to be similar to the whole. The idea that traders and investors buy and sell in harmony or share the same risk (adjusted for

The similarity between the returns over minutes, hours, weeks, months and years is referred to as self-similarity (see part 2 above for data). That is the parts appear to be similar to the whole. The idea that traders and investors buy and sell in harmony or share the same risk (adjusted for the duration) is related to this self-similarity (more on this in the coming weeks).

What about the “long-term” trends?

Besides the obvious fact that we will all be dead in the long-term, asset classes that are linked to the economic health of a country tend to exhibit lower risk “over the long term”. This is true of stocks and bonds.

On the other hand, asset classes that do not depend on countries economic health will not exhibit lower risk with longer duration. Examples are currency trading and gold.

These are facts that we will have to incorporate into the fractal market hypothesis. I shall present data to support these in the coming weeks (it is, of course, available in the Peters’s book). I had if you excuse the expression, an orgasm when I saw it for the first time.

Not So Fast!

Now, the financial services industry uses this idea – risk associated with equity investing is lower with increasing duration – to sell mutual funds, ulips and stocks. What we as investors should recognise is, that an unexpected event can trigger a stampede at any time and crash the market. Then years of investing gains would be wiped out in a few days. Therefore risk management is key. For this, we need to understand risk the right way. Hence the need to at least appreciate the bare essentials associated with Fractal Market hypothesis.

To be continued ….


  1. Chapter 3 of Fractal Market Analysis: Applying Chaos Theory to Investment and Economics, by Edgar E Peters.
  2. Sensex suffers 12th biggest fall since 2008: http://www.thehindu.com/business/sensex-suffers-12th-biggest-fall-since-2008/article2476576.ece
  3. Biggest falls in Indian stock market history: http://www.rediff.com/money/2008/oct/24bcrisis10.htm


Kolkata DIY Investor Workshop May 28th, 2017

Register for the Kolkata DIY Investor Workshop May 28th, 2017

You Can Be Rich Too With Goal-Based Investing

You can be rich too with goal based investing is my new book with PV Subramanyam. If you have not yet got the book, check out the reviews below and use the links to buy.
Reader Quotes:

particularly useful for first time investors

Every earner should read this

Five stars. Gifted my friend. He found it very helpful

If you want a book that’s unbiased and that will hold your hand and walk you through the personal finance jungle, then buy this.. the best thing 300 bucks could buy you.

Gift it to your Friends and Relatives whom you care more. Already follower of Pattu and Subra’s forum. Ordered 4 more copies to give gift to my friends and eagerly waiting to read

The best book ever on Financial Freedom Planning. Go get it now!

Your first investment should be buying this book

The (nine online) calculators are really awesome and will give you all possible insights

Thank you, readers, for your generous support and patronage.

Amazon Hardcover Rs. 317. 21% OFF

Kindle at Amazon.in (Rs. 87 75% OFF)

Google Rs. 307
Infibeam Now just Rs. 315 24% OFF.

If you use a mobikwik wallet, and purchase via infibeam, you can get up to 100% cashback!!

Bookadda Rs. 344. Flipkart Rs. 359

Amazon.com ($ 3.70 or Rs. 267)

  • Ask the right questions about money
  • get simple solutions
  • Define your goals clearly with worksheets
  • Calculate the correct asset allocation for each goal.
  • Find out how much insurance cover you need, and how much you need to invest with nine online calculator modules
  • Learn to choose mutual funds qualitatively and quantitatively.

More information is available here: A Beginner’s Guide To Make Your Money Dreams Come True!

What Readers Say

Want to conduct a sales-free "basics of money management" session in your office?
I conduct free seminars to employees or societies. Only the very basics and getting-started steps are discussed (no scary math):For example: How to define financial goals, how to save tax with a clear goal in mind; How to use a credit card for maximum benefit; When to buy a house; How to start investing; where to invest; how to invest for and after retirement etc. depending on the audience. If you are interested, you can contact me: freefincal [at] Gmail [dot] com. I can do the talk via conferencing software, so there is no cost for your company. If you want me to travel, you need to cover my airfare (I live in Chennai)

Connect with us on social media

Do check out my books

You Can Be Rich Too with Goal-Based InvestingYou can be rich too with goal based investing

My first book is meant to help you ask the right questions, seek the right answers and since it comes with nine online calculators, you can also create customg solutions for your lifestye!Get it now.  It is also available in Kindle format.

Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want

Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you want My second book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a youngearner

The ultimate guide to travel by Pranav Surya

Travel-Training-Kit-Cover This is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step.  Get the pdf for ₹199 (instant download)

Create a "from start to finish" financial plan with this free robo advisory software template

Free Apps for your Android Phone

All calculators from our book, “You can be Rich Too” are now available on Google Play!
Install Financial Freedom App! (Google Play Store)
Install Freefincal Retirement Planner App! (Google Play Store)
Find out if you have enough to say "FU" to your employer (Google Play Store)

About Freefincal

Freefincal has open-source, comprehensive Excel spreadsheets, tools, analysis and unbiased, conflict of interest-free commentary on different aspects of personal finance and investing. If you find the content useful, please consider supporting us by (1) sharing our articles and (2) disabling ad-blockers for our site if you are using one. We do not accept sponsored posts, links or guest posts request from content writers and agencies.

Blog Comment Policy

Your thoughts are vital to the health of this blog and are the driving force behind the analysis and calculators that you see here. We welcome criticism and differing opinions. I will do my very best to respond to all comments asap. Please do not include hyperlinks or email ids in the comment body. Such comments will be moderated and I reserve the right to delete the entire comment or remove the links before approving them.

2 thoughts on “Why Do Stock Markets Crash?

  1. I’ve been following Bill Williams and Elliott waves for a few years now with great results and it blew my mind initially to see how the markets are actually a natural phenomenon. No matter which market you pick, same thing repeats over and over again. Thanks for this post

    1. Thank you. Elliot waves are not fractals though. In fact, fractal practitioners are dismissive about their (E waves) ability to predict. I shall post on this in more detail soon. Of course, I cannot comment on your success.

Comments are closed.