Over 30 years ago, on 19 October 1987 (dubbed “Black Monday"), the US stock market benchmark Dow Jones Industrial Average (DJIA) index nosedived by 22%—representing the biggest-ever single day fall. Unfortunately, the world moved on without absorbing the lessons properly. Not surprisingly many avoidable though extreme disruptions, with some similarity to that of 1987, have been hitting the markets with remarkable regularity. Lessons from Black Monday could have cushioned the impact of events like the Long-Term Capital Management disaster (1998), the dot-com bust (1997-2001) and the global financial crisis (2007-2009)—if not prevented them altogether.

Black Monday had its genesis in the usual suspects—unbridled greed, herd mentality, inability to raise even basic questions, poor memory of past market developments, and an uncontrollable urge to not be left behind peers. There was a new factor as well—the unrestricted application of derivative instruments, often by inexperienced people.

Eventually, the market’s resilience after the crash was quite remarkable. The DJIA bottomed out in October 1987 itself and recovered in less than two years, in a sense paving the way for the next disaster in the late 1990s. While the current conditions in 2017 do not resemble the environment leading to Black Monday, it is important not to gloss over the lessons of the 1987 crash.

There were three sets of exponents in the market bubble leading up to Black Monday. Listed here, they had one thing in common—they all were based on sophisticated strategies that seemed simple, elegant and practical: risk arbitrageurs (who were thriving on betting on who would take over whom in the ongoing takeover boom), cash-future arbitrageurs, and portfolio insurance buyers. Portfolio insurance is actually a dynamic hedging strategy designed to prevent a stock portfolio from dipping below a predetermined floor. In practice, the hedges are placed by algorithmic models automatically, by selling futures if the underlying stocks see a price erosion. Thus, as portfolio value declines, hedges increase, and vice versa. The instrument looked like an amazingly simple way to enjoy the best of both the worlds—participate in the upside if the portfolio is moving up and limit the downside if markets are tripping. The strategy was based on the now famous Black-Scholes equation for option pricing but had never been utilized earlier.

Now, why did the markets fall precipitously on 19 October 1987? To say gravity wouldn’t be an oversimplification. The markets had risen too high too fast, becoming ripe for a rout. By August 1987, the DJIA index had registered about 40% gains for the year. In fact, the five-year bull run since 1982 had catapulted the DJIA to 3.5x times. The US economy too was advancing strongly, having registered five straight years of expansion.

The lessons for stock investors from Black Monday, listed below, were quite clear and must still be kept in focus though current market conditions seem far from a bubble zone. If some profit seems too good to be true then chances are quite high it is so. It is imperative for investors to steadfastly refuse invitations for a free lunch. If a large majority of market participants are optimistic and excited about markets, and are acting accordingly, then it would be wise to be on one’s toes. At any point in time, inability to justify a course correction for markets in future does not guarantee continued momentum, or even status quo. The principle of regression to mean must be an important guiding principle.

Even simple-looking derivatives should be handled with care. People with less than perfect understanding of, and experience in, these instruments should treat derivatives as nothing but weapons of mass destruction. There is another and deeper issue with derivatives. Superficially, the methods and outcomes look as simple as they seem compelling. Slowly, untrained people get sucked into the cauldron, drawn in by the temptation of large, easy profits. After some time, the application of a particular derivative instrument becomes so widespread that contagion risks grow exponentially and uncontrollably. Now one seemingly innocuous mistake by an untrained hand can be all it takes to bring down the entire edifice. Even smart and experienced professionals find themselves helpless once the genie has been set free.

Quantitative models, even if they are mathematically rigorous and practically simple, are unable to capture human emotions. Hence they can become irrelevant precisely when they are needed the most. A quantitative strategy based on assumptions on correlations—among certain assets— derived from intricate data from the past can fall flat on its face when the markets turn irrational. These correlations can in no time swing from a substantially negative value to a meaningfully positive one. Thus, an asset supposed to hedge another one may end up doubling the portfolio exposure in reality, thus piling on the misery. Hence such models are best left to expert practitioners with deep understanding and rich experience.

Black Monday was the first market crash when notions of a liquidity crunch and fat tails (an anomaly as per which extreme events occur more frequently than predicted by models based on a normal distribution curve) made their presence felt—of course, with disastrous consequences. They must be accorded high emphasis in risk-management models.

Vipul Prasad is founder and CEO of Magadh Capital, a long-only Indian equity fund based in Mumbai. Comments are welcome at theirview@livemint.com

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