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Lessons From The 87 Crash

October has an ominous place in investors’ minds for a variety of reasons. Most notably, October 19th marks the 30th anniversary of the 1987 stock market “crash.” On that one day, the Dow Jones Industrials fell 508 points. That 22% drop remains the largest single day percentage drop in U.S. stock market history.

To put that in perspective, it would be the same as if the market fell today by more than 5,000 points in a day.

As if this one event wasn’t bad enough, over 39 days from August 24 to October 19, the stock market plummeted 36%!

It is quite natural to try and figure out what happened…and then to not let it happen again. However, there was no “smoking gun,” but rather a combination of events.

In the fall of 1987, the Federal Reserve raised short-term interest rates from 5.5% to 6% over three months. Throughout the year the market repriced long-term rates on the 10-Year U.S. Treasury from 7.23% to more than 10%. High interest rates typically act as a gravitational drag upon stock prices.

Valuations on the U.S. stock market soared. From August 1985 to August of 1987 the Price to Earnings ratio of the broad market increased from 11 to 18.

There was ongoing conflict with Iran and inflation was rapidly increasing. Oil had doubled over the previous year and the Consumer Price Index tripled during the first nine months of 1987.

Between 1985 and 1987 the Dollar depreciated significantly against the British Pound and the Japanese Yen. This contributed to the trade deficit increasing while Congress was proposing tax-cuts that made many uneasy.

Also during 1987, the use of new computerized trading was being broadly implemented—even if it was not truly understood. When the selling started in Asia computer algorithms saw this and automatically placed more sell orders. Cascading sell orders continued to drive prices down, which in turn, caused more selling. It became a self-fulfilling prophecy.

All of this is easy to evaluate and analyze after-the-fact. However, how does this affect investors today and what can be learned?

The entire selloff in 1987did little to change or decrease the sales or earnings of businesses. The long-term value of any business is determined by its sales and earnings. Thirty-nine trading days does not determine the long-term viability of a business.

Despite all the drama over that short period in 1987, the results were far different if you slept through the year. If you were Rip Van Winkle and stayed invested but took a long nap, you finished the year with a positive gain of 5%. Although a 5% return may not be fun for news outlets to hype, it offers perspective.

Don’t be too clever with short-term trading strategies. You might guess nine variables right, but the tenth one may cut your legs out from under you. Short-term trading strategies do not work with any long-term regularity.

Although the last eight years have had relatively low volatility, it is not always the case. You must build your portfolio in a manner that allows you to sleep at night. The stock market has lost as much as 38% in a single year and 60% over a two-year period.

Mentally and emotionally, you must know there can, and will, be tremendous short-term volatility. Knowing markets are volatile and unpredictable, never invest in stocks unless you have a 10 year or longer time frame.

Human nature cannot be repealed. People will overreact and be emotional. Just don’t be one of those people. Stock panics breed more panic. However, scary events don’t last forever. Stay logical and disciplined.

There is no rulebook for the next crash. Even if it is similar, it will have different circumstances. All you can do is manage your portfolio relative to your goals today.

Lastly, there is nothing wrong with holding cash. Although it will not keep pace with taxes and inflation long-term, it allows short-term stability, flexibility and liquidity.

With the stock market at record highs now is the time to review what you own and why. A proper assessment should always include a determination of your time frames and your tolerance for volatility. If you’ll do this now, you’ll sleep much better the next time things go bump in the night. 

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Dave Sather is a CERTIFIED FINANCIAL PLANNER and owner of Sather Financial Group. His column, Money Matters, publishes every other week.