Stocks provide you with an opportunity for growth, but they offer no principal guarantees. That means you could lose your investment if your holdings drop in value. Stock prices are prone to fluctuation, and this volatility increases significantly during a credit crisis. Many investors shy away from the market during such crises, while other investors view a credit crisis as a great buying opportunity.
During severe recessions, consumers and businesses often experience a decrease in income. Consequently, borrowers lack the funds to cover their debt obligations. As loan defaults mount, banks curtail lending to reduce the risk of further losses. When lending dries up, people cannot easily get credit to buy homes, cars and other goods. This exacerbates the problem, because sales drop and businesses lay off workers and curtail production. Eventually, the economy reaches a virtual standstill as banks effectively suspend their normal lending practices. Economists refer to this situation as a credit crisis. In this environment, stock prices tend to fall partly because firms have reduced earnings and partly because cash-strapped investors liquidate their holdings.
Many investors are fearful of buying stocks during a credit crisis because falling stock prices threaten to erode their retirement or college savings accounts. Speculators are one class of investors who remain fairly active even during a credit crisis. By definition, speculators invest in speculative securities. In a normal economic environment, speculators buy junk bonds and other low-cost, high-risk securities. During a credit crisis, speculators often buy stocks and attempt to make quick gains by taking advantage of market volatility. Speculators include wealthy individuals and institutional investors such as hedge funds. Such investors have sufficient assets to remain solvent even if stock prices continue to tumble.
Short sellers are investors who attempt to profit from market downturns. Such investors borrow stocks from brokerage firms and promise to return the stocks at a later date. Short selling involves selling the broker's stock and buying the same stock back for a lower price. The short seller pockets the difference between the sale price and the repurchase cost. If stock prices rise, short sellers lose money, because the cost of buying back the stocks exceeds the original sale price. Some economists argue that short sellers make a credit crisis worse. When short sellers dump large quantities of stock, the supply outstrips the demand, and this drives down stock prices.
Some wealth and institutional long-term investors view a credit crisis as a good buying opportunity. During a severe recession, the stock market as a whole drops in value. Consequently, stocks in financially stable firms drop in unison with stocks in struggling firms. Value seekers attempt to distinguish the stable companies from the firms that genuinely have severe financial problems. In theory, stocks in the stable firms should rapidly rise in value as the economy recovers. Investors with substantial assets and a long-term investment time horizon can afford to wait it out.