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What You Should Learn From Yesterday's Crash

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Many investors rely on the idea that the financial markets are efficient, with prices that accurately reflect all the information available to them. It's hard to imagine, though, how anyone could still truly believe that after the way the stock market acted yesterday.

Fast and furious
For a few minutes between about 2:45 and 3:00 p.m. yesterday, it looked like 2008's market meltdown was replaying itself. In about 20 minutes, the Dow went from being down 250 points to a 1,000-point drop. Within the next 10 minutes, though, the average had recovered all but 150 points of its plunge.

Prices on individual stocks saw similar whipsaws. According to Yahoo! Finance, Procter & Gamble (NYSE: PG  ) saw prices drop by over $20 per share -- fully a third of its total value -- before recovering nearly all of its losses by the close. 3M (NYSE: MMM  ) saw a similar $20 range in its shares in intraday trading.

In some cases, the losses were even more surreal. Yahoo! Finance data showed one broad-based exchange-traded fund, iShares Russell 1000 Value Index (NYSE: IWD  ) , recorded some trades for a ridiculous $0.08 -- on shares that closed the day above $59. Accenture (NYSE: ACN  ) reported a $0.01 low for the day. Sam Adams-maker Boston Beer (NYSE: SAM  ) shares also went for a single penny -- and some other stocks saw trades for mere fractions of a cent. On the whole, hundreds of billions of dollars in market value disappeared and reappeared in an amazingly brief period of time.

As of this morning, rumors are still flying, but it's not clear yet exactly what happened. Various news sources have reported that the culprit may have been an erroneously entered trade on a stock index futures contract. The rumored typo on a sell order on equity index futures, replacing $16 million with $16 billion, would have been a large enough transaction -- especially when coupled with automatic trading program responses -- to wreak the sort of havoc that the markets saw yesterday afternoon.

Don't get burned
When markets are functioning normally, it's relatively simple to buy and sell whatever stocks you want. Although some stocks are small and illiquid enough to merit extra care, you can generally count on big blue-chip stocks to trade normally, with relatively narrow bid-ask spreads and accurate pricing.

But this isn't the first time the market has seen quick plunges like this. Throughout the past 25 years, violent swings have plagued the markets from time to time. The problem even prompted the exchanges to set up circuit-breaker rules that call for temporary trading closures when stocks drop below certain levels in a single day.

There are a couple of big ways in which a snapback like this hurts investors:

  • If you panic and use a market order to sell your shares at any price, you have no assurance that you'll receive any particular minimum amount for your stock.
  • Some traders use stop-loss orders to try to lock in profits. If the stock falls below the level that you set in your stop-loss order, then your broker will automatically enter a sell order for your shares. Unfortunately, during quick plunges, these stop-loss orders tend to cascade on each other, causing an avalanche of selling pressure that makes a drop worse than it would otherwise be.

Get relief
It appears that both the New York Stock Exchange, run by NYSE Euronext (NYSE: NYX  ) , and the Nasdaq, run by Nasdaq OMX Group (Nasdaq: NDAQ  ) , are going to cancel some, but not all, of the trades in many of the hundreds of stocks that experienced these ridiculous price moves. But you can't always take for granted that you'll get relief -- and so you should always take care to protect yourself.

Luckily, it's easy to avoid these problems. All you need to do is to use limit orders. That way, you set a minimum price you're willing to accept when you sell. The risk is that you won't always get a buyer for that price -- but you won't have to worry about taking a big hit when the market malfunctions. Your broker may let you enter limits on stop-loss orders as well.

Better yet, a limit order can help you take advantage of situations like this. If you enter an order well below the market, you may get a chance on days like this to buy shares on the cheap -- and you don't even have to be at your computer. Most of the time, those orders will never execute -- but when they do, they can be extremely lucrative.

Stay vigilant
Unfortunately, thinking that the financial markets are perfectly efficient is naive, and it can be dangerous as well. By being careful about how you go about buying and selling shares, you can avoid making unnecessary and potentially costly mistakes.

Was your broker up to the task of dealing with yesterday's market turmoil? If not, check out our Discount Broker Center for ideas on where to switch.

Fool contributor Dan Caplinger took the opportunity yesterday to reminisce about his experience of the 1987 stock market crash. He doesn't own shares of the companies mentioned in this article. Accenture, 3M, and Nasdaq OMX Group are Motley Fool Inside Value recommendations. NYSE Euronext is a Rule Breakers selection. Motley Fool Options has recommended writing covered calls on Nasdaq OMX Group. The Fool owns shares of Procter & Gamble, which is also an Income Investor choice. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy will never crash on you.


Read/Post Comments (11) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 07, 2010, at 11:16 AM, ZachGTFG wrote:

    Yesterday I had the unique pleasure of sitting on a trading desk while this carnage was in full force. I have only been trading for about five months so it was quite a shock to watch the greatest volatility of all time play out in front of me. Furthermore, we recorded everything that was being said on our desk and posted a video on YouTube under "Live Reaction to the Market Crash." The video provides professional perspective of yesterday's events as they occurred.

  • Report this Comment On May 07, 2010, at 11:20 AM, mikecart1 wrote:

    What I learned:

    1) Jim Cramer doesn't know what he is talking about.

    2) MSNBC doesn't know what it is talking about.

    3) TMF doesn't know what is is talking about.

    4) Stock market is one big pile of manure.

    5) I'd have better odds robbing a bank and risking jail time or paradise at this point.

  • Report this Comment On May 07, 2010, at 11:26 AM, IIcx wrote:

    rec +1, good article

  • Report this Comment On May 07, 2010, at 12:03 PM, daveandrae wrote:

    What I have learned- (after nearly 12 years of investing)

    1. Any stock bought with a sell stop underneath the purchase price is guaranteed to lose the Investor money.

    2. Any non professional buying on margin is speculating with his money.

    3. An index that is capable of going down 1000 points on any given day is also capable of going UP 1000 points on any given day.

    4. Every major market decline, must also be, a major rally in dividend yield and book value. Most people don't see this. They sell harder and harder as prices go lower and lower. Which is yet another reason why most people are not wealthy. Everyone loves a sale until there's one wall street.

    5. Most people have the brains for the stock market. Very few have the stomach. You need both.

    Thomas Edmonds

  • Report this Comment On May 07, 2010, at 12:08 PM, Borbality wrote:

    LOL mikecart1

    If anyone really knew anything we'd all be rich by now.

  • Report this Comment On May 07, 2010, at 2:04 PM, brickcityman wrote:

    I learned that when the big dogs make a real mistake, they get a mulligan. Lets face it the puppeteers of the market got their wires crossed and decided just to start the show over.

    ... Anybody know any good ways to participate in micro credit so I can invest money more directly?

  • Report this Comment On May 07, 2010, at 3:18 PM, thedivisonbell wrote:

    I learned - Panic is for speculators. Real Investors shoot for long term. Patience is the key for making money. When market is down as it is just don't look at the portfolio, if red will make you sad and if you have money buy some good companies at great prices today. Those who are seeling now should go to Las Vegas, investement is not for them. And all the real investors keep hanging on.

  • Report this Comment On May 07, 2010, at 4:55 PM, Retired31B5M wrote:

    The thing that bothers me is that I literall missed getting som bargians of a lifetime by just a few minutes. I caught a news blurb about the market dropping, hopped online to check my portfolio and my watchlist and saw some of amy favorite stocks selling for unbeleiveble prices.

    I figure I got by 'buy' orders in about 2 minutes after sanity returned to the market and missed out on the deals.

  • Report this Comment On May 07, 2010, at 9:44 PM, stokerz1 wrote:

    Hi, I am a very new investor with stocks, and I noticed that people in the live chat seemed to be ready to start buying some stock shares next week after the volatile week we've had. Why are people not buying today, but rather next week? I am just trying to build my investing knowledge, so all insight, knowledge, and advice is welcome! Thanks.

  • Report this Comment On May 07, 2010, at 10:00 PM, ColoradoSkiGuyRJ wrote:

    Stokerz1: Het there, I am a fairly new investor so I speak with humility but I think I have an answer for you. More seasoned investors, feel free to correct me... one of the biggest problems right now is the Greek debt crisis and this is a big weekend for that crisis. Germany doesn't seem to know if it even wants to help and they have crucial votes in their parliament this weekend. EU is also meeting this weekend to try and sort stuff out and determine their actual aid package. But who know what will happen? Maybe they are stubborn and decide to piss all over the Euro... which means there will be a sizeable sell-off come monday. Combine that factor with what we saw on wednesday and nobody wants to be long going into the weekend. Then again they could quit dragging their feet and do something about the Euro and you will see great opportunity for some quick trades and good money. As many others here have said, it depends on your time horizon. If you are in for the long haul, no sweat if you are long going into the weekend.

  • Report this Comment On May 08, 2010, at 3:57 PM, daveandrae wrote:

    Stokerz-

    The best time to buy is ALWAYS when you have the money.

    I added to my Pfizer position last Monday at a market price of 16.92. The stock closed Friday at 16.44. Did I do something wrong?

    Absolutely Not.

    Remember, a LONG TERM investor is always, always, always, mentally, buying a small piece of the business. Speculators "rent stocks." Thus, it should not make any difference to you whether it is Monday, or Thursday, June, or September, 2003, or 2010, or whether the Dow Jones is at 11,000 or 6500. The only thing you be interested in, is the price the market is quoting you.

    If a twelve pack of Coke is selling at a market price of 3 for 10 bucks, it does not matter that there is 12 inches of snow outside, you know to load up your freaking cart.

    The New York stock exchange is not any different. All it is just a big super market of companies. Just like you're going to need food for the rest of your life, you're going to need money.

    Thus, a 44 year old man , such as myself, is far more likely to be a net buyer of the market over the next 20 years as opposed to a net seller. So what should I want the market to do?

    I should want it to go DOWN. Way down!

    For example-

    Eight years ago, I had 200 shares of Pfizer. Today, I have 2,044.53 shares. In 2002, the stock was trading at 29. It closed Friday at 16 and change. Thus, as you can see, the market is much more about time IN, not "timing."

    Why? Because, like most people, I do not have 35-40 grand in spare cash sitting around. All I have to invest is just a few hundred, month in and month out. I've just let my position pile up through the magic of time and compound interest.

    In addition, every major decline in market price, must also mean, that there is major rally in the dividend yield and the book value of the business. Just as every major market advance is extinguishing the underlying book value and the dividend yield. Most people don't see this. They sell harder and harder as prices go lower and lower, yet fall all over themselves buying stocks like Apple. This is yet another reason why most people are not wealthy.

    If more people bought their stocks like they bought their gasoline, we would all be better off as investors.

    Hope this helps,

    Thomas Edmonds

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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