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CHAPEL HILL, N.C. — A 1987-magnitude stock market crash could happen at any time.
Keep that in mind this week as commentators note the 26th anniversary of that crash, the worst in U.S. stock market history. If another crash of that magnitude were to occur today, the Dow (.DJI) would shed more than 3,400 in a single session.
Now consider this: Another crash that big is inevitable. No amount of government regulation can prevent it. You need to adjust your investment strategy accordingly.
That, at least, is the conclusion that emerges from academic research a decade ago into the frequency of market crashes. Xavier Gabaix, a finance professor at New York University and one of the co-authors of that research, told me earlier this week that their initial conclusion has been confirmed by numerous subsequent studies.
The researchers derived a complex formula for predicting the frequency of large daily stock market movements. The predictions of that formula are summarized in the accompanying chart.
Imagine, for example, employing their formula on the day after 1987's crash. It would have predicted that there would be 32 trading sessions between then and today in which the stock market's daily percentage change would be at least 5%. The actual number in the case of the Dow turns out to have been 27, which must be judged remarkably close in the otherwise unpredictable world of the stock market.
If the frequency of crashes of various magnitudes is so predictable, shouldn't they be preventable?
Professor Gabaix says no. It's their frequency that is predictable, not their timing.
Furthermore, crashes are inevitable because every market, to a more or less similar degree, is dominated by its largest investors. And when those large investors together want to get out of stocks, which they on occasion will want to do, they will inevitably find ways of doing so — regardless of downside protections such as circuit breakers that may be in place.
Profession Gabaix therefore recommends that we construct our portfolios so that a crash as large as 1987's won't be fatal.
Unfortunately, he added, that's easier said than done. That's because the financial cushions that protect us from a crash reduce profitability when there is none. After long periods in which no big crash occurs, the pressure becomes overwhelming to sacrifice those cushions in pursuit of short-term profits.
Warren Buffett, CEO of Berkshire Hathaway (BRKB), is the rare manager who doesn't succumb to that temptation. As he wrote in his company's most recent annual report, he operates "with many redundant layers of liquidity, and we avoid any sort of obligation that could drain our cash in a material way. That reduces our returns in 99 years out of 100. But we will survive in the 100th while many others fail. And we will sleep well in all 100."
Buffett's investment virtue has become more and more rare as the stock market in recent years has climbed — and climbed and climbed.
As a result, I judge the current market environment as a so-called "kids' market" — the famous phrase introduced by Adam Smith, the pseudonymous author, in his classic book from the late 1960s entitled "The Money Game." He used that phrase to refer to an investment environment in which the advisers and traders making the most money are those too young to remember the last bear market.
"Memory can get in the way of such a jolly market," Smith wrote.
Smith created a fictional character called The Great Winfield, who exploited kids' markets by only hiring investment managers who were not yet 30 years of age: "The strength of my kids is that they are too young to remember anything bad, and they are making so much money that they feel invincible. Now you know and I know that one day the orchestra will stop playing and the wind will rattle through the broken window panes, and the anticipation of this freezes [the rest of] us" who are old enough to remember.
So if you are old enough to remember the 1987 crash — good for you. You may very well live long enough to witness another one that big. In the meantime, your memory will serve you well as you judge what kind of risk is appropriate.
And if you aren't old enough, then you need to pay especially close attention to the academic studies that conclude another crash is someday inevitable.
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