Twenty-five years later, are there any lasting lessons from the
October 1987 stock market crash?
You may recall that on October 19, 1987, the Dow Jones
Industrial Average plummeted 22.6 percent. This drop was far steeper than the
12.8 percent decline on October 28, 1929, the day many consider the start of
the Great Depression and it “immediately raised fears of an international
economic crisis and a recession in the United States,” according to the Los Angeles Times.
Although the crash was mind-boggling and is firmly etched in
investment lore, on a long-term performance chart, it shows up as just a blip. In
fact, in the first eight months of 1987, the Dow rose more than 40 percent,
and, despite the crash, the Dow – amazingly
– finished the year with a gain.
With the benefit of 25 years, here are a few investment lessons
to remember:
1.
Don’t panic.
The crash was painful, but the market was back to breakeven just two years
later.
2.
Valuation matters.
Traditional valuation metrics such as price earnings ratios and dividend yields
were flashing red back in 1987 which suggested the market was ripe for a fall –
so pay attention to valuation.
3.
Stay diversified.
Even though correlation among asset classes tends to rise during times of
market stress, it’s still important to own a variety of asset classes as over
time, it may help balance your portfolio.
4.
Invest responsibly.
People who borrowed money to invest in the stock market or made high-risk bets
got burned when the market crashed. Always invest within your risk tolerance so
a repeat of 1987 won’t put you out of business.
Sources: Los Angeles
Times; The Motley Fool; Forbes
When asked what the stock market will do, the great banker
J.P. Morgan replied, “It will fluctuate.” Indeed, as October 1987 shows, stocks
do fluctuate – sometimes dramatically. Knowing that and remembering the four
lessons above could help make you a better investor.
HOW GOOD ARE YOU at
predicting the future? Well, despite a bazillion bits of information at our
fingertips and unbelievable computing power, humans are still pretty bad at it.
Let’s use an example that gets to the heart of the financial
crisis. As described in Nate Silver’s book, The
Signal and the Noise, back in 2007 Standard & Poor’s Corporation
(S&P) gave investment ratings to a particularly complex type of security
called collateralized debt obligation (CDO). For CDO’s that were rated AAA – the
highest rating possible – S&P said the likelihood that a piece of debt
within those CDO’s would default within five years was a miniscule 0.12
percent. That’s about one chance in 850.
Now, you probably know where this is going. Guess what the
actual default rate was? According to S&P, it was around 28 percent. Simple
math says the actual default rate was more than 200 times higher than S&P predicted and, as Silver wrote,
“This is just about as complete a failure as it is possible to make in a
prediction.”
It’s easy to poke fun at bad predictions; however, there is
a larger point here. First, we can’t predict the future so we always need a
plan B. And, second, we need to differentiate between risk and uncertainty.
Economist Frank Knight said risk involves situations where
we can calculate the probability of a particular outcome. For example,
actuaries can calculate the probability of a 60-year old male dying within 10
years because they have historical mortality statistics that don’t change much
from year to year.
By contrast, uncertainty has no historical data to use as a
solid basis for making a prediction. For example, predicting the outcome of war
in Syria is not knowable because there’s no set of historical data or
probability distribution on which to base the prediction.
It’s just our luck that the financial markets seem to
contain elements of risk and uncertainty. However, we can try to use that to
our benefit by being cognizant when the risk/reward seems to be in our favor
while at the same time, having plan B in case uncertainty tries to spoil the
party.
Weekly Focus – Think About It…
“It is a truth very certain that when it is not in our power
to determine what is true we ought to follow what is most probable.”
--Descartes, French philosopher,
mathematician, writer
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