Learning Lessons from the 30th Anniversary of Black Monday

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It was 30 years ago on Oct. 19 that the U.S. stock markets experienced Black Monday, which still is the largest single-day decline in the stock indexes.

The Dow Jones Industrial Average declined 22.6% in one trading session. That was 508 points at the time and about 5,775 points at today’s level. But that was only part of the story.

The decline really was spread over four trading days that had a cumulative decline of 28.5%. Looking further back, the major indexes peaked at the end of August with returns of about 40% for the year. They were down about 15% from their highs by October 15, 1987.

There’s still some disagreement about what triggered the stock market drop. Some people point to a decision a few months earlier to reduce the value of the dollar.

There were other political and economic events at the time that receive blame from some quarters. Of course, there were investors ready to take profits from a bull market that began in 1982 and that many never believed had a solid foundation.

But I think there’s a consensus that the swiftness and steepness of the decline were caused by technology and quantitative investing. In particular, portfolio insurance is given most of the blame.

For those who don’t recall, portfolio insurance essentially involved hedging a stock portfolio with futures contracts. But the trades were made automatically by computers based on market moves. As stocks or stock indexes declined, the computers bought more futures that bet on falling market prices.

Enough big investors were using some version of portfolio insurance that the automated trading systems fed on themselves, triggering more selling. Eventually, other investors joined the selling. There are several fine books that go into detail about what happened during that period.

Much has changed in the markets. There now are circuit breakers and other provisions that slow or stop trading to avoid significant, compressed declines.

The exchanges are much more automated. There is disagreement about whether that makes such a crash more or less likely. But it is known that on Black Monday some of the floor traders were refusing to answer their telephones or take orders. In other words, the market makers declined to make markets.

It is important to draw the right lessons from Black Monday.

Some people say such a crash isn’t possible, because of all the changes in rules and technology. I don’t think you should rely on that. Perhaps a crash wouldn’t be as compressed as in 1987, but a high percentage decline in a fairly short period still can happen.

There are a lot of technology-driven investment strategies. They’ve pushed markets steadily higher the last few years and could push them down just as steadily sometime in the next few years.

Also, investors still have a lot of psychological scars from the financial crisis. It wouldn’t take much for them to go back into defensive mode and sell risky investments.

Others say the lesson is to ignore the short-term fluctuations and invest in stocks for the long term. Following Black Monday, stocks recovered fairly quickly and went on an almost uninterrupted bull market that culminated in the technology stock bubble in the late 1990s.

The value of long-term investing is good for a younger investor to weigh. But it can create problems for an older investor. The five years before and after retirement are the most dangerous in retirement planning.

A sharp decline in your portfolio value during that time can disrupt your retirement plans. A younger investor can wait for a new bull market and capture the long-term average return over a lifetime.

A retired investor might not have enough time to wait for the recovery. Someone who retires at exactly the wrong time and has a stock-heavy portfolio might run out of money before the portfolio can recover.

When you’re in or near retirement, you should recognize that something like 1987 or an extended bear market such as 2007-2009 might occur. You might not be able to overcome such a decline.

That’s why you need to have either a more balanced portfolio, so your portfolio isn’t so closely tied to the stock indexes, or a strategy for reducing your stock market exposure and protecting your capital when market risk is higher than normal.

Thank you.

Until next time,

Robert Carlson

Robert Carlson is editor of the monthly newsletter, Retirement Watch. In it, he provides independent, objective research covering all the financial issues of retirement and retirement planning. Carlson also is Chairman of the Board of Trustees of the Fairfax County Employees’ Retirement System and the founder of Carlson Wealth Advisors, L.L.C.