You Could Lose a Quarter of Your Wealth in a Few Hours
The 1987 stock market crash reminds us that asset prices don’t always go up
One of my favorite stock market stories involves a domestic commercial flight taken by former Federal Reserve chair, Alan Greenspan. One part of this story could never happen again today, but the other part that could happen offers important investing lessons as the Dow Jones Average recently reached record heights, closing over 34,000 for the first time, and earlier this month bitcoin hit a new high.
Traveling Back 35 Years
Let’s travel back in time to late-1986 to see what was happening in the stock market. The Dow closed that year at a level of 1896 (coincidently, 1896 was the year the Dow index originated), up from the previous year’s close of 1547. During the year, the average daily point gain was 1.38. Typical for the time, daily Dow Jones Industrial Average point changes were reported to two decimal places (this is a relevant tidbit for our story, as you’ll see later).
On August 11, 1987, Ronald Regan’s Vice-President, George H. Bush, swore in Greenspan as the new chair of the Federal Reserve. Taking over from 6 feet-7 inches Paul Volcker, who was known for his tough stance fighting inflation, the 5 feet-4 inches Greenspan had big shoes to fill, both figuratively and literally. The Dow closed at over 2680 that day, a new record. Further record highs would follow over the next two weeks, but unbeknownst to market participants, the August 25, 1987 record of 2722 wouldn’t be surpassed for another two years.
Setting the Stage for a Stock Market Collapse
In early September 1987, Greenspan sent a message to the markets about his concern with potential inflation, raising the Federal Reserve’s discount rate for the first time in three years. Then in October, a number of events contributed to market jitters. Higher-than-expected trade-deficit figures fueled fears of further declines in the dollar relative to major trading partners. Furthermore, the U.S. had entered into a currency-stabilization pact among G-7 nations. But the dollar was sent into a further decline when Treasury Secretary James Baker commented that the U.S. might let the dollar drop unless West Germany eased credit (these were in the days before West and East Germany were reunified, in 1990). An inflationary concern that was particularly tied to oil prices was the continuing war between Iran and Iraq, two oil-rich countries.
Many also blamed the October market volatility on “program trading” involving the stock market and derivatives markets such as options and futures, a relatively new process of using computers to execute automated trading strategies. One such strategy was known as portfolio insurance and involved short-selling stock index futures. If there was mispricing between stock index futures and the underlying stocks, then arbitrageurs would step in, often by buying stock index futures while selling stocks, which could hasten stock price declines and increase volatility.
There were psychological factors at play as well — think of how we react to round number markers, and why an item selling for $10.00 seems a lot more expensive than one selling for $9.99. On October 14, 1987, long-term U.S. bond yield rose above 10 percent, catching investor attention, and making bonds look much more attractive relative to stocks. Then on Friday, October 16, the Dow dropped by more than 100 points for the first time ever, to a level of 2247 — not the greatest percentage drop, although at 4.6 percent, quite large, and certainly a headline-grabber. Investors stewed nervously over the weekend, wondering what would happen when markets opened on Monday.
On Monday, October 19, 1987, a day now known as Black Monday, despite the recent market turmoil, Greenspan decided to fulfill a commitment by flying from Washington, D.C. to Dallas, Texas in order to attend the American Bankers Association meeting, where he was scheduled to speak the next day. These were in the days when commercial airline passengers had no communication with the outside world when flying, and also the days before the World Wide Web and mobile phones. Once you entered the airplane, you were incommunicado and not aware of what was happening in the outside world not only for the duration of the flight, but until you could access a pay phone in the airport lobby or to speak with someone. Before boarding his four-hour flight, the Dow was already down a stunning 200 points, or over 8 percent.
When he arrived in Dallas, the stock exchanges were closed for trading for the day. As reported in The Wall Street Journal, the first question he asked the official greeting him was “How did the market close?” The reply was “Down five-oh-eight.” Thinking the market had recovered and ended the day virtually flat, down just 5.08 points, Greenspan was fleetingly relieved. But he had the decimal points misplaced: the Dow had dropped a staggering 508 points, or 22.6 percent, to a level of 1739, the worst one-day loss in history — no subsequent daily drop in the Dow, percentage-wise, has come close, although on March 16, 2020, near the beginning of the Covid-19 pandemic, the Dow dropped almost 13 percent. The chart below tracks the Dow’s course throughout 1987, up to the Black Monday drop — the year’s gains were wiped out.
Imagine Losing a Quarter of Your Wealth in a Few Hours
Why I like this story is because it allows us to personalize a catastrophic market event and to try imagine what Greenspan — arguably the most powerful person to be able to impact the U.S. economy as well as the stock market — was feeling in that particular moment. Imagine going from relief to shock, when he suddenly realized the astonishing one-day wealth loss he and all stock market investors had suffered, as he was stuck on a plane. And that loss of about a quarter of stock market wealth is based on investors who were well-diversified — some of those who weren’t faced even greater one-day losses.
We don’t think about investment risk very often, perhaps only when we’re forced to, like when we open a new investment account and are asked some risk-related questions. It’s easy to respond to one of those risk-based questionnaires — asking how you would feel if you lost, say, 10 percent of your portfolio — while you are sitting on your comfy sofa sipping your morning latte on a warm, sunny weekend. But what’s more difficult is trying to really reflect on how we would feel if something similar to October 19, 1987 happened today, and you had tens or hundreds of thousands of dollars of your hard-earned money invested. Would you feel disbelief? Fear? Anger? Sadness? Despondency? Would you panic, and liquidate your entire portfolio, as some investors did? The same goes for more recent although less severe one-day drops during the start of the Financial Crisis in 2007, and the start of the 2020 pandemic.
In hindsight, panic selling would not have served investors well — by June 1989, the Dow was again above 2500. This chart below of the daily percentage changes in the Dow since 1896 shows that large drops are often — but not always — followed by large gains. One of the biggest one-day gains ever occurred two days after Black Monday, when the Dow gained more than 10 percent.
Of course, the Greenspan story could never be repeated today in the sense that if the Washington-Dallas flight had occurred nowadays, during the flight Greenspan would have Internet access and would know what was happening in the market every second — perhaps he could have taken some immediate action, or tried to calm the markets. On the other hand, there is nothing to stop such a one-day drop in the market today, or even greater. Prior to 1987, considering the Dow daily returns since 1896, the worst-case scenario we had as a reference point was the one-day drop of 12.8 percent on October 28, 1929 (which was followed the next day by an 11.7 percent drop, then the following day a gain of 12.3 percent). Each major one-day drop has been unique. It’s hard to anticipate all of the economic, geopolitical, psychological, and technical factors that went into the mix on October 19, 1987 — a perfect storm perhaps. I wonder what today’s perfect storm might look like.
Let me hasten to add that a one-day drop exceeding Black Monday is extremely unlikely, and there is no indication of such a pending drop, but for any investment, it’s important to understand what could happen, rather than what we expect or would like to happen. Have a plan; figure out what you would do before such events occur, and then hopefully remain calm if and when they occur. It’s exciting to watch stock prices and other asset process hit new highs, but remember that stock prices — as well as cryptocurrencies, real estate, and any other assets — don’t just move in one direction.
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Stephen Foerster is a co-author, with Andrew Lo, of In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest, Princeton University Press (August 17, 2021).