Unpredictable extreme events happen all the time.
Thirty-six years ago, something so improbable happened, it was virtually impossible: The Dow Jones Industrial Average plunged nearly 23 percent in a single day.
Prior to Monday, October 19, 1987 (now known as Black Monday), such a massive market decline was not considered possible because statistics placed such a decline at an incredibly rare event of twenty-two standard deviations. How rare is a twenty-two standard deviation event? Writing about the decline in his 2000 book When genius failedjournalist Roger Lowenstein from Wall Street Journal “Economists later estimated that, based on the historical volatility of the market, if the market had been open every day since the creation of the Universe, the odds would still have been that it would not fall that much in one single day. In fact, if the life of the Universe had repeated itself a billion times, such a crash would still have been theoretically “improbable”.
Yet it happened.
Portfolio Insurance and the Dangers of Feedback Loops
What is the cause of the fall? Several factors contributed to the accident:
- Economic growth slowed during the first three quarters of 1987 and inflation increased. Given the recent experience of stagflation in the 1970s, investors were nervous.
- The stock market had fallen nearly 10% in the week leading up to Black Monday, heightening investor fears.
- Program trading using computers was relatively new and unsophisticated. Losses in the week leading up to Black Monday and opening losses triggered computer program trading with little or no human intervention.
And then there is the unfortunate strategy of “portfolio insurance.” Portfolio insurance involved the use of puts and calls to hedge a portfolio against losses while still allowing it to benefit from gains. To maintain portfolio insurance, portfolio managers had to adjust hedges as the market fluctuated. The use of portfolio insurance grew in popularity in the years leading up to Black Monday, and by October 1987, tens of billions of dollars were being managed under the portfolio insurance program.
For each individual investor, using portfolio insurance to protect against losses was entirely rational: enjoying gains while limiting losses sounds great. But on a system scale, deploying that much capital using an identical strategy was catastrophic.
As market volatility increased in the weeks leading up to Black Monday, the portfolio insurance strategy caused investment managers to sell securities to raise funds to increase their hedges. Losses generated by selling into a falling market prompted portfolio insurance algorithms to sell even more assets to place more hedges. This feedback loop of losses generated even more sales, creating even more losses, leading to more sales, and so on. The next moment, the market had plunged 23%.
In his book A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial InnovationRichard Bookstaber, who in 1987 was head of risk management at Morgan Stanley
M.S.
What Black Monday teaches us
The main lesson of Black Monday is that highly improbable events can and do happen all the time. Events such as terrorist attacks, wars, earthquakes, tsunamis, pandemics, murder hornet infestations, boats stuck in shipping canals, and stock market crashes that come out of nowhere happen all the time . Each event may be improbable in itself, but these sorts of improbable things happen enough that we can expect them to inevitably happen. Knowing this, it would be best if you designed your investment portfolio to weather unlikely events, which is accomplished by diversifying across asset types (stocks, bonds, real estate, private equity) and building up a margin security by having sufficient liquidity and low-risk assets.
The second lesson is that the market recovers from extreme events. Over the past 40 years, we have experienced many extreme events, the most significant being Black Monday, 9/11, the financial crisis and the pandemic. And yet, the stock market has increased more than 20-fold since Black Monday. This means that taking a long-term perspective is essential for investing success. Try to ignore short-term ups and downs, even if they are extreme.
The third lesson is that the unpredictable nature of extreme events means that relying on predictions of the future to make investment decisions is not a good strategy. Investment experts didn’t predict Black Monday, the 9/11 attacks, or the pandemic. Instead of relying on what we now know to be fanciful predictions of stock movements and returns, you will be better served if you:
- Accept the uncertainty inherent in markets; prepare yourself for gigantic changes that could (and will) be imminent.
- Stress test your portfolios by modeling what would happen if we experienced another 1929 crash, another Black Monday, a 2000 dot-com collapse, or a 2008-2009 financial crisis (or something even worse) . Will your portfolio still meet your cash flow needs?
- Test your stress. Can you emotionally handle this much volatility?
- Maintain an adequate margin of safety to deal with extreme negative events.
- Avoid excessive debt.
After you’ve designed your wallet to weather wild storms, move on. Moving in and out of investments can lead to missing the market’s best days, which will have devastating consequences on portfolio returns.