On Monday, Oct. 19, 1987, the Dow Jones Industrial average fell 22.6 percent in one day. It's been 30 years since then, but the event still holds some valuable lessons for any investor today.
New innovations, such as program trading, which powered portfolio insurance and trading on indexes and index futures, were blamed for what happened on Black Monday.
At the time, as much as half of the market's trading volume was programmatic. When index futures in Chicago were lower than the actual indexes on Wall Street, the programs would sell stocks. Unfortunately, the rout was on when the futures market remained lower throughout the day and investors panicked and sold, too.
From the beginning of 1987 through August of that year, the Dow had jumped up 44 percent in value — but then fell roughly 10 percent in the week before Black Monday. Those declines happened amid rising tensions between the United States and Iran and were exacerbated by Iran shooting missiles at U.S. ships the prior Thursday and Friday.
On the Monday after, Asian markets led a day of turmoil as an already skittish market was rattled by U.S. warships shelling an Iranian oil platform. European trading started badly and only got worse when the U.S. stock market opened. By the end of the day — and into the following day in Asia and Australia — markets around the world had experienced their biggest daily declines ever. New Zealand equities, for example, lost more than 60 percent of their value, and Hong Kong fell more than 40 percent in one day.
Despite all those extreme swings during 1987, the Dow started the year at a price of 1,900 and ended it at 1,938. Here are four important insights to apply today from that market crash.
1. Don't believe the hype. Prior to the crash, the U.S. stock market was considered a surefire winner. After all, it had climbed 44 percent following two fantastic performing years. After the crash, U.S. equities were lambasted as a bad investment that would never recover. Neither turned out to be true.
It's important to remember that, in investing, the more people believe any one thing, the more the opposite viewpoint turns out to be correct. The crowd is seldom right when they all agree, because the market price reflects everyone's collective optimism (or pessimism). Asset prices become expensive when investors are too optimistic, and cheap when they are too pessimistic.
Phrased another way, markets rise when investors are concerned about risk and decline when most investors have less concern about risk. We are at an increasingly optimistic time in the market right now, as such investments are becoming historically expensive. That's not a reason to sell, but it is a great time to assess whether you are taking more risk than you need in your current portfolio.
2. Diversification works better on the way up than the way down. There's a lot of research that supports the importance of diversifying as a method to help reduce risk. But when a crash happens, asset classes can behave similarly and a diversification strategy may not prevent a loss.
When investors run from risk, they leave all speculative assets — especially if the U.S. stock market falls more than 20 percent. During the '87 crash, equities from all countries suffered, and oil, gold and high-yield debt fell in value, too. Only "safe" assets such as cash and Treasurys held up. Make sure you are diversified across strategies and across asset classes, but don't be surprised if several investments behave the same way in the short term at extreme stress points.
3. Anticipation beats reaction. Timing the market is not something any people should try to do themselves, but ensuring that an investment portfolio is not more risky than a person can handle always works. It's important for any investor to be able to withstand extreme conditions with their current investment allocation and be mentally prepared for what it will feel like when the portfolio loses value.
We suggest investors imagine their portfolios declining 25 percent, and then calculate what that would mean in dollars. Even though the math is the same, many folks can imagine withstanding a larger percentage decline than they can withstand a loss in actual dollars. If you aren't sure you could sit tight, then adjust your portfolio risk to ensure you can stay with it.
4. Time heals all wounds. If you had purchased the Dow on the Friday before the big sell off, you would have purchased the Dow at 2,245, and suffered a 23 percent decline the very next trading day. But at the 30-year anniversary of the crash, the Dow is still more than 10 times higher. That doesn't include all the dividends along the way.
Time is your greatest ally, if you do not sell when markets decline. This is especially true if you are still working and contributing to your investments. However, when you are living on your investments, ensure you have several years of savings not subject to the whims of the market. That cushion will allow you to ride out the decline and the following recovery. Taking money out of the market at lows locks in losses. Let time work for you.
The great battle: Fear vs. greed
Many of us have never experienced a day in the market like Oct. 19, 1987, because new trading halts have since been instituted that limit their ability to occur. However, many investors have experienced the two 50 percent bear markets that happened in the aftermath of the dot.com bust in the early 2000s and the housing bubble collapse of 2008. Every kind of bear market hurts, but those investors who remain cautiously optimistic, patient and disciplined in their financial decisions can win, even if it takes some time to turn out to be true.
— By Joe Duran, founder and CEO of United Capital Financial Partners