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This year has seen a lot of talk about the prospect of a stock market crash. In reality, nobody ever knows for sure when the market will next crash. Maybe it will be next week, maybe next month, maybe next year — or maybe even longer.
But it can be helpful to understand what a stock market crash is – and what it isn’t.
What happens when the market crashes?
Technically, a crash is a 20% or greater drop in value in a short period of time. Sometimes, a crash comes out of the blue. In other instances, warning signs bubble away for ages before materialising.
During a crash, lots of share prices fall – sometimes dramatically. That can shake investor confidence. Some investors need to sell to improve liquidity and an underlying cause (such as a financial crisis) can further undermine confidence, so a crash can feel like a snowball that picks up momentum as it goes.
But not all shares necessarily fall during a crash. Some may actually rise, for example if they are seen as a safe haven in a time of uncertainty.
Also, it is important to note that a share price is just a share price. Until you sell a share you own, a lower price may mean you make a paper loss but that is not the same as an actual loss.
In a crash, many investors hang onto shares in the hope their prices recover. Ordinarily, at least some of them will over time.
It’s not all bad though
So far, so gloomy. On top of that, a crash can be psychologically unnerving — particularly for investors who have not lived through one before.
But there is a silver lining to this – a crash can be a brilliant buying opportunity for the investor who is willing to wade into the market to pick up shares others are dumping.
That is because a crash often sees some share prices fall because they were overvalued before, but others may fall simply because of a generally bad sentiment – sometimes tinged by panic.
Quality companies are therefore sometimes suddenly on offer for a much cheaper price than they were before – and perhaps than they will be in the future.
Getting ready for the next crash
That can be a great buying window. However, the window of opportunity can be short-lived. So it pays to be prepared before the crash comes.
One share on my list to look out for if it suddenly becomes available more cheaply is Rolls-Royce (LSE: RR). As I see it, there is a lot to like about the FTSE 100 aeronautical engineer.
Barriers to entry in its industry are high and designing and building jet engines is time-consuming, costly and requires specialist expertise.
Rolls has that expertise in spades, as well as proprietary technology and a large installed base of engines.
But there is always a risk that a sudden slowdown in civil aviation demand could hurt profitability. The Rolls-Royce share price was in pennies following the 2020 pandemic-triggered stock market crash.
The current price does not offer me enough margin of safety for the risk, I reckon. But the share is on my watchlist in case it again falls to a bargain price during the next stock market crash!
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Christopher Ruane does not hold any positions in the companies mentioned.
This story originally appeared on Motley Fool
