10/18/2012 11:45 PM ET|
Another crash like 1987 is inevitable
New research suggests that periodic free-falls in the market are unavoidable. Investors need to cushion their portfolios.
A trader holds his head on the floor of the New York Stock Exchange on Oct. 19, 1987, after the Dow crashed 22.6%.
Prepare yourself for another stock market crash as big as the free-fall in October 1987.
That's a daunting prospect, indeed. At current levels, such a decline would mean a plunge in the Dow Jones Industrial Average ($NDU) of more than 3,000 points in a single trading session.
And we're kidding ourselves if we think that market regulatory reforms such as circuit breakers will be able to prevent it.
These sobering truths are what emerge from a fascinating line of recent academic research into the frequency of market crashes. Recognizing them is perhaps the best way for us to respect this week's 25th anniversary of the Oct. 19, 1987, "Black Monday" crash, when the Dow plunged 22.6%.
This research traces to "A Theory of Large Fluctuations in Stock Market Activity," a study you can find on the Social Science Research Network that was conducted a decade ago by Xavier Gabaix, a finance professor at New York University, and three scientists at Boston University's Center for Polymer Studies: H. Eugene Stanley; Parameswaran Gopikrishnan, and Vasiliki Plerou.
In numerous follow-up studies, Gabaix said in a telephone interview earlier this week, the original findings have only been strengthened.
No way to stop losses
The researchers crafted a complex mathematical formula for predicting the frequency of large daily stock market movements. Though they believe their formula rests on a solid theoretical foundation, the proof of the pudding is in the eating. And they found that not only does the U.S. stock market over the last century closely adhere to the formula, so do international markets.
A single-session drop of at least 20%, for example, is predicted -- over long periods -- to occur once every 104 years, on average, but it could happen at any time. That's why you always have to prepare for it, because you don't know when it will occur.
If the frequency of crashes of various magnitudes is predictable, shouldn't precipitous slides also be preventable?
Gabaix says no. Crashes are an inevitable feature of the investment arena because every market, to a more or less similar degree, is dominated by its largest investors. When those large investors collectively want to get out of stocks, which will happen on occasion, they will find ways to circumvent any downside protections, such as circuit breakers, that may be in place.
Gabaix therefore recommends that all of us -- whether individuals or large institutional investors, such as banks and mutual funds -- cushion our portfolios so that a crash as large as 1987's wouldn't be fatal.
Unfortunately, he added, for most investors that's easier said than done. Those cushions are a drag on portfolio performance as long as the market doesn't plunge. After big stretches in which no major crash occurs, the pressure becomes overwhelming to toss out those cushions in pursuit of short-term profits.
The bottom line? Regulators are tilting at windmills in trying to formulate reforms that would prevent large daily market drops. Even worse, these regulatory efforts lull gullible investors into a false sense of security.
Repeat after me: Another stock market crash as big as 1987's is going to happen. Period.
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VIDEO ON MSN MONEY
I would rather lose my money in the stock market than watch Barry Obama steal another six trillion with untold interest from the American middle class.
Here's a scenario for all of you Kool Aid drinkers and heads-in-the-sand retirement fund holders...
It's Friday. If Europe and China collapse over the weekend, you get to stare at your statement balance for two days while macro markets fail. On Monday, you will see American markets open and set to the prevailing conditions (drop immensely). At best, you could make electronic adjustments, but those will take effect at 4pm Monday, not 9am. Between 9am and 4pm on Monday, super computers will buy and sell major clients, not retirement funds, to stable or recovery positions. You get screwed. Considering the falsehoods known and bubble state of ALL markets... why are you thinking that nothing will happen when it has no other choice? When was the last time you pulled a glass dish out of a 400 degree oven that had baked for hours, using your bare hands because you thought- nothing will happen? Why do you treat your life savings any differently?
THE SKY IS FALLING! THE SKY IS FALLING! The idiots who write these articles
must have nothing to do.. They say protect your portfolio, but NEVER say how..
One point never explained was the Flash Crash of spring, 2010… Any idiot can write an
article like this one.. Please, Moron, go back to work at Mickey D’s …
Wow ! Just the mere mention of markets falling puts investors on the defensive, we're down over 100 pts already. Black Monday in 87' was very different than the collapse in 08'. In 87', things recovered very quickly and since 08', we're still struggling. Today, we have to work harder & longer for the same returns in order to maintain healthy positions in our portfolios. As long as our financial systems remains artificially inflated, we're going to continue to have this 'cloud' hovering over us.
Solution ? Pay down your debt, deleverage yourself/business. While debt is not necessarily bad, mismanagement of it will 'kill' your business.
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