Crash of ’87: The three big lessons for every investor

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Stock market crashes always seem so simple in retrospect.

It's easy, for instance, to point out signs of mounting anxiety in the run-up to Black Monday in 1987. The Dow Jones industrial average had spent the first seven months of the year rocketing higher. Then, in mid-August, the market wavered. Its downward momentum picked up speed in mid-October, and culminated a few days later in a stunning and unprecedented 23-per-cent drop on Monday, Oct. 19.

Looking back on a market chart of 1987, it's tempting to think that if you had been on the job back then, you would have picked up on the trend well ahead of time.

But chances are you wouldn't have. I can say that with some confidence because I was there and I didn't, despite the obsessive attention I was lavishing on the market.

At the time, I was just starting out as a business journalist and shared a house with a friend who had recently begun working as an analyst at a leading money-management firm. We spent every evening discussing stocks, the market and how we were going to get rich.

But neither of us had a premonition of what was to come on Black Monday. What I do recall is the dazed look on my friend's face the evening after the crash and his tales of the panicked discussions among his bosses over the next few days. How would they ever explain these enormous losses to their clients?

For a while, his employer considered simply not issuing account statements that month. This, of course, was in the days before online access to account information. Customers had to wait for monthly statements to see how they were doing. So, the thinking went, if clients didn't get a statement, there was a chance they might remain blissfully unaware of how much their personal wealth had suffered.

Fortunately, saner counsel eventually prevailed and my friend's employer mailed out statements that month as usual. But the mere fact that a well-known Toronto money manager could even consider the idea of going silent on the disaster testifies to the paralyzing shock of the moment.

The shock was understandable. Three decades later, there's still no single compelling explanation for what prompted the crash. Sure, U.S. treasury secretary James Baker had mulled a possible devaluation of the U.S. dollar the weekend before Black Monday, but his thunderings on the topic sounded like standard political rhetoric, not an immediate threat. His bluster certainly didn't seem, then or now, to be any reason to vaporize nearly a quarter of U.S. stock market value.

Yet, despite the enduring mystery of Black Monday, investors can learn a lot from the debacle. Given today's frothy valuations and record highs – highlighted by the Dow's first surge over 23,000 on Wednesday – three lessons seem particularly appropriate.

The first is that market crashes always seem to come out of nowhere. There is no magic indicator, no red light, that flashes when trouble is nigh. So be prepared for experts to be shocked by the next market debacle. They always are.

The second lesson is that the plumbing of the financial system matters – a lot.

Money managers had adopted several nifty new techniques before Black Monday, including a strategy known as portfolio insurance that attempted to hedge against losses by systematically selling stock index futures if stocks fell. This was often combined with program-trading strategies that would automatically buy or sell stocks according to predetermined conditions.

Unfortunately, the combination proved toxic when everyone rushed into the dubious safety of portfolio insurance programs on Black Monday. Instead of calming the panic, the new strategies amplified the bedlam, with every wave of selling prompting yet another wave of selling.

Regulators have long since installed circuit-breaker rules on major exchanges to prevent a recurrence of this nightmare. But it's difficult to look at the portfolio insurance strategies of 1987 and not see them reflected in today's volatility control strategies and risk-parity approaches. They, too, attempt to reduce the market's swings. But they, too, may fail if everyone rushes for the exit at the same time.

A final lesson of the 1987 crash is that it's tough to know what a plummeting stock market signifies. The crash in 1929 signalled the start of the Great Depression and the one in 2008 heralded the Great Recession. In contrast, the 1987 crash wasn't followed by any downturn. The economy continued to grow and the damage to stock values was quickly erased.

Three decades later, I don't blame myself for not foreseeing the crash. But what I do regret is not observing the buying opportunity that opens up when the stock market crashes during fundamentally good economic times. If I had bought the day after Black Monday, I would be far richer today.

But, hey, all is not lost. Given the current market giddiness, I suspect I may have a new chance to put my observation into action soon enough.