When the next crash comes, they’ll blame the machines. And they’ll be wrong – again.

October 19, 1987 is known as “Black Monday.” On that day, the Dow Jones Industrial Average lost more than a fifth of its value. The 22.6% drop was the biggest one-day percentage loss in history… even bigger than the crash of 1929.

What caused it?

The popular explanation is “portfolio insurance.” This strategy used the futures market to try to protect a portfolio against a decline. I won’t go into all the details today – but basically, it involved setting up a computer program to sell stocks automatically as the market went lower.

No one was taking the time to look at the fundamentals of the individual stocks. And so, the theory went, selling snowballed out of control and led to that big decline in 1987.

Now, most people take the “portfolio insurance” story as a given. (The Financial Times matter-of-factly declared it “a leading contributor to the 1987 ‘Black Monday’ crash.”)

I say the theory is bunk.

Today, I’ll show you why… And I’ll share three steps you can take that will help you get through market crashes (regardless of their causes) better than most everyone else…

The portfolio insurance theory has some big holes in it, as one Wall Street observer noted:

Unfortunately for the theory, it does not explain very well why markets around the world crashed simultaneously or why the decline stopped. It is at an utter loss to explain why many indexes around the world that had no computer trading fell further than the Dow Jones Industrial Index.

This quote comes from a book titled Ubiquity: Why Catastrophes Happen by science writer Mark Buchanan. In it, he covers catastrophes of all kinds – earthquakes, wars, and yes, stock market crashes.

We always have ready explanations for these big events after they happen. But Buchanan uses insights from physics to show that “all past efforts to perceive cycles, progressions, and understandable patterns of change in history have necessarily been doomed to failure.”

One of his most memorable examples involves using a simple sand pile to try to find out what causes an avalanche. If you take a grain of sand and then pile another grain of sand on top of it and another and another… How long before the pile collapses? What triggers it?

Three physicists from Brookhaven National Laboratory tried to answer this question in their lab. They ran lots of tests. And what did they find?

They found there was no way to predict an avalanche, or its size. There was no pattern. Sometimes the avalanches would be small, sometimes large. It seemed any grain of sand could trigger an avalanche at almost any time.

Buchanan writes:

What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.

In other words, triggers are unpredictable…

Buchanan adds more evidence in a variety of fields to reach “the surprising conclusion that even the greatest of events have no special or exceptional causes.”

This is hard for most people to swallow. They want a reason for why something happened. They want to have a theory. But most things happen for reasons we don’t understand.

When the 1987 crash happened, I was 15 years old. I remember being intrigued by the whole thing, but not really understanding what was going on. The mystery of the crash helped fuel my interest in finance – and stocks specifically.

In the ensuing 30 years, I’ve lived through many more market catastrophes. They’re never easy to get through. Here are three steps to help you:

  • Always invest carefully. I always chuckle when I hear people say, “Now is the time to be careful” – as if there is a time to be careless! You should always invest carefully in a portfolio of stocks in well-financed companies at good valuations with managers who have skin in the game.
  • Only invest with money you can afford to leave alone for a while. The longer, the better… but I think three years is probably a minimum. If you can do without the money you invest for at least three years, then this horizon will help limit the risk of having to yank your money out at a bad price just because of some stock market calamity like a 1987. You can afford to wait for better prices.
  • Keep something in reserve. You want to have the ability to add to your favorites if the market gives you a chance to do so at great prices. You can’t take advantage of the next Black Monday if you have no money.

If you follow these three key points, you’ll get through better than most everyone else.

Regards,

Chris Mayer

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Source: Daily Wealth