How Do Investors Lose Money When the Stock Market Crashes?

Over the last 100 years, there have been several large stock market crashes that have plagued the American financial system. For example, during the Great Depression, stock prices dropped to 10% of their previous highs and during the crash of 1987, the market fell more than 20% in one day.

Due to the way stocks are traded, investors can lose quite a bit of money if they don't understand how fluctuating share prices affect their wealth. In the simplest sense, investors buy shares at a certain price and can then sell the shares to realize capital gains. However, if the share price drops dramatically, the investor will not realize a gain.

For example, suppose an investor buys 1,000 shares in a company for a total of $1,000. Due to a stock market crash, the price of the shares drops 75%. As a result, the investor's position falls from 1,000 shares worth $1,000 to 1,000 shares worth $250. In this case, if the investor sells the position, he or she will incur a net loss of $750. However, if the investor doesn't panic and leaves the money in the investment, there's a good chance he or she will eventually recoup the loss when the market rebounds. (For related reading, see: One Thing to Never Do When the Stock Market Goes Down.)

Another way an investor can lose large amounts of money in a stock market crash is by buying on margin. In this investment strategy, investors borrow money to make a profit. More specifically, an investor pools his or her own money along with a very large amount of borrowed money to make a profit on small gains in the stock market. Once the investor sells the position and repays the loan and interest, a small profit will remain.

For example, if an investor borrows $999 from the bank at 5% interest and combines it with $1.00 of his or her own savings, that investor will have $1,000 available for investment purposes. If that money is invested in a stock that yields a 6% return, the investor will receive a total of $1,060. After repaying the loan (with interest), about $11 will be left over as profit. Based on the investor's personal investment of $1, this would represent a return of more than 1000%. (For more on this, read: Margin Trading.)

This strategy certainly works if the market goes up, but if the market crashes, the investor will be in a lot of trouble. For example, if the value of the $1,000 investment drops to $100, the investor will not only lose the dollar he or she contributed personally but will also owe more than $950 to the bank (that's $950 owed on an initial $1.00 investment by the investor).

In the events leading up to the Great Depression, many investors used very large margin positions to take advantage of this strategy. However, when the depression hit, these investors worsened their overall financial situations because not only did they lose everything they owned, they also owed large amounts of money. Because lending institutions could not get any money back from investors, many banks had to declare bankruptcy. In order to prevent such events from occurring again, the Securities and Exchange Commission created regulations that prevent investors from taking large positions on margin.

By taking the long-term view when the market realizes a loss and thinking long and hard before buying on margin, an investor can minimize the amount of money they lose in a stock market crash.

(For related reading, see: When Stock Prices Drop, Where's the Money?)