U.S. stocks already are having a rough October — two trading days in. October is the most volatile month for stocks — and when stocks suffered their two worst crashes in U.S. market history.
Moreover, there’s a 0.06% chance that the stock market this month will experience a one-day crash as bad as 1987’s Black Monday.
Those odds don’t seem like much — but they are not zero. The Dow Jones Industrial Average DJIA, -0.03% tumbled 22.6% on Oct. 19, 1987, Black Monday. An equivalent percentage drop from its current level would take more than 7,700 points off the Dow in a single trading day.
Few investors in the market nowadays remember the trauma of Black Monday. Those who do may reassure themselves that a similar crash couldn’t happen today, given market reforms that were instituted in the wake of the selloff.
They are kidding themselves, according to a study conducted by Xavier Gabaix, a professor of economics and finance at Harvard. He and his-coauthors derived a formula that predicts the frequency, over long periods of time, of large daily swings in the market. Upon testing the formula against hundreds of years of stock market returns in both the U.S. and around the world, they found the formula to be impressively accurate.
For example, Gabaix’s formula predicts that a 22.6% drop in the market will occur every 150 years, on average, over long periods of time. That doesn’t mean such a crash will occur every 150 years, since this predicted frequency is an average over extremely long periods. So the market could experience no such crash over a 150-year period, or experience two of them (or more).
What you can’t conclude, however, is that the odds of a crash are zero.
Why market reforms can’t prevent a crash
You might object to this conclusion on the grounds that market reforms instituted since 1987 will prevent another crash from occurring — circuit breakers, trading halts and other safeguards. But, as Gabaix has explained to me many times in interviews over the years, such reforms are powerless to prevent a crash. That’s because all markets are dominated by their largest investors, and when many of them want to get out of the market simultaneously, for whatever reason, the market will crash.
For example, even if trading halts and other restrictions succeed in preventing these large investors from selling on U.S. exchanges, they can still sell on foreign exchanges where many U.S. stocks also trade. They can also sell short with stock index futures contracts or via the purchase of put options. You’re kidding yourself if you think these large investors will be prevented from getting out if they want to.
Gabaix’s research underlines why it’s so important to prepare for so-called black swan events like market crashes that are sudden, awful, unpredictable and rare. Notice that, by this definition, they are unpredictable, so it’s false comfort to believe you can anticipate future black swans in time to reduce your portfolio risk and thereby sidestep a market crash. Did you foresee the COVID-induced bear market in time to avoid big losses?
The investment implication is to make changes to your portfolio that will protect you from a crash, if and when it occurs. It’s like buying fire insurance on your house. Most of you will not ever have your houses burn down, but that’s not a reason forego fire insurance. I doubt any of you complain about having to purchase such insurance, since the downside risk of losing everything is sufficiently awful.
What might be the functional equivalent of fire insurance for your stock portfolio? I discussed several different possibilities in a column this summer, and I direct your attention to it.
One possibility is to regularly allocate a small percentage of your portfolio to long-dated, out of the money put options on the S&P 500 SPX, -0.19%. In my previous column on this subject, I reported on one such strategy that each year allocated 3.33% to an S&P 500 put option that was 60% out of the money and with two years left before expiration.
In this particular case, your portfolio’s “fire insurance” carries a premium of 3.33% per year. That doesn’t seem prohibitive, especially since in backtesting back to 2006 this strategy beat the S&P 500 itself. So over this particular period there was no net cost to your insurance. Not bad.
It won’t always work out this well, of course, and this is not the only black swan strategy. But it gives you an idea. The anniversary of the two worst crashes in U.S. market history is an excellent time in which to consider insuring your portfolio against black swans.