The Stock Market Crash of 1987: Timeless Investing Lessons from Black Monday and the Risk Appetite Index

by Alexander Green, Investment Director
Friday, March 09, 2007: Issue #649

On October 19, 1987, the Dow lost 22.6% of its value in a single session.

The cause of the stock market crash of 1987, know as Black Monday, is still debated. After all, no one was shot. No currency crashed. No government failed.

The market simply gapped down at the opening and – between the computer-driven program trades and individuals dumping shares “because everyone else was selling” – it didn’t stop falling until more than $500 billion in equity value had been erased.

What Can Investors Learn From the 1987 Crash?

This was a sobering day for investors. It underscores the unpredictability of markets in the short-term. And it provides an object lesson for those wondering what the heck’s been going on with the market over the past few weeks.

After all, the sudden selloff we witnessed last week wasn’t caused by a blue-chip bankruptcy or a major hedge fund blowup. Instead, thousands of investors suddenly decided en masse to hit the exit, even though there have been no large-scale surprises concerning economic growth, interest rates or earnings.

While the initial drop on February 27th was a bit bracing, the market’s decline has been orderly and prices (while volatile) have stabilized somewhat.

Still, this is a market to watch closely. Why? Because over the past few years, many investors around the world have grown increasingly cavalier about risk.

Just ask Jonathan Wilmot and the Appetite Risk Index…

Wilmot is a research analyst with Credit Suisse First Boston. And his “Risk Appetite Index” shows that global investors’ speculative fever recently reached a 12-year high and is near the all-time high reached just before the stock market crash of 1987.

His index, a measurement of investors’ willingness to put their capital “in the fire,” is pretty ingenious. Wilmot examines the type of investments that investors currently favor – and extrapolates from that data whether they’re feeling risk averse or just the opposite.

Right now, it seems, many of them are content to take their hard-earned investment capital to the dog track.

Over the past four years investors have been increasing their exposure to growth stocks over value stocks, small-caps over large-caps, foreign markets over domestic markets, and emerging markets over developed markets. They’ve also been increasing their exposure to corporate bonds over government bonds and junk bonds over investment-grade bonds.

Add to this aggressive stance record volume in options and futures trading, blatant (and highly-leveraged) speculation in the real estate market, and the ardent desire for Mom and Pop to plunk a portion of their retirement money in someone’s (anyone’s) hedge fund and you have the Risk Appetite Index ringing like a fire alarm.

This is not good.

How to Put the 1987 Stock Market Crash Lessons Into Action Today

Does it mean you should cash in your chips and move to the sidelines? No.

But it’s an excellent time for a gut check. For starters, that means remembering that stocks give the best return over the long haul because they often scare the be’jesus out of investors in the short term.

Next you should make sure now that you’re not taking more risk in your portfolio than you’re comfortable with. That means diversifying beyond stocks into:

• high-grade bonds,
• inflation-adjusted Treasuries,
• real estate investment trusts
• and precious metals, for example.

Dividing your portfolio in different, non-correlated assets like these – and rebalancing annually – increases your annual returns and smoothes out the inevitable bumps along the way.

You should also run a trailing stop behind your individual stock positions. (More on this in a future column.) This protects both your profits and your principal. If you don’t use a sell discipline, chances are you’re merely wishin’ and hopin’ – and flying by the seat of your pants.

In short, your investment strategy should be implemented with an eye to not only maximizing returns but also limiting risk.

That doesn’t mean retreating to the safety of cash. (After taxes and inflation, you’d be left with very little return.) But don’t throw caution to the wind either, thinking only of your upside potential.

Because once a genuine market correction gets under way, it’s generally too late to do anything terribly smart.

Or as legendary mutual fund manager Peter Lynch warned, “If you’re gonna panic, do it early.”

Good Investing,

Alex

Comments

By submitting your comment you agree to adhere to our Comment Policy and Privacy Policy.

Check out our selection of daily investment research: