How to prepare for the next market catastrophe

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From Chris Mayer at Bonner & Partners:
You may have seen the headlines…
“Dow Drops More Than 1,100 Points in Stock-Market Rout,” screamed The Wall Street Journal on Monday afternoon.
“U.S. stocks suffer worst fall in 6 years,” reported the Financial Times.
Soon after, the mainstream media was quick to pronounce the “reasons” for the drop.
It was the robo-traders…
… the “short volatility” crowd…
… the rising interest rates…
You get the idea.
But the wisest thing I’ve heard this week is a piece of advice from veteran financial writer Jason Zweig: “Stop trying to figure out the stock market.”
It goes up and it goes down. Nobody knows what it’s going to do.
The biggest challenges during times like this are psychological. Stay calm, cool, and rational. Otherwise, forget it… The markets will chew you up.
To show you what I mean, let’s first go back to 1987…

Black Monday

October 19, 1987 is known as “Black Monday.” On that day, the Dow Jones Industrial Average lost more than a fifth of its value.
The 22.6% drop was the biggest one-day percentage loss in history. Even bigger than the crash of 1929.
What caused it?
The popular explanation is to finger “portfolio insurance.” The strategy used the futures market to try to protect a portfolio against a decline.
It’s hard to explain exactly how it worked, but basically it meant selling stocks as the market went lower.
This was all done by a computer program. Thus, the selling happened automatically. There was no attention paid to the fundamentals of individual stocks. There was nobody working to answer that essential question: “What is this stock worth?”
And so, the theory went, portfolio insurance selling snowballed out of control and led to that big decline in 1987.
Now, most people take the “portfolio insurance” story as a given. (The Financial Times matter-of-factly declared it “a leading contributor to the 1987 ‘Black Monday’ crash.”)
I say the theory is bunk.
In a moment, I’ll show you why…
I’ll also share three steps you can take that will help you get through market crashes (regardless of their causes) better than most everyone else.

Why Catastrophes Happen

There is no theory that really explains why the 1987 crash happened. Why that day? Why not the next day? Or the next week? What was the trigger, exactly? No one knows…
The portfolio insurance theory has some big holes in it, as one Wall Street observer noted:
The theory that gained the most credence [in explaining the 1987 crash] was that the crash was caused by so-called portfolio insurance computer programs, which in essence sold stocks as the market went lower…
Unfortunately for the theory, it does not explain very well why markets around the world crashed simultaneously or why the decline stopped. It is at an utter loss to explain why many indexes around the world that had no computer trading fell further than the Dow Jones Industrial Index.
This quote comes from a book titled Ubiquity: Why Catastrophes Happen by science writer Mark Buchanan. I recommend the book. Buchanan is a good writer and the ideas he covers apply to all areas of life.
Published in 2002, this book’s thesis is timeless. Buchanan covers catastrophes of all kinds – earthquakes, wars, and yes, stock market crashes. He writes how we always have ready explanations for these big events after they happen.
But he shows us, using insights from physics, how our existence “must be punctuated by dramatic, unpredictable upheavals; and to see why all past efforts to perceive cycles, progressions, and understandable patterns of change in history have necessarily been doomed to failure.”
One of Buchanan’s memorable examples involves using a simple sand pile to try to find out what causes an avalanche.
If you take a grain of sand and then pile another grain of sand on top of it and another and another… How long before the pile collapses? What triggers it?
Three physicists from Brookhaven National Laboratory tried to answer this question in their lab. They ran lots of tests. And what did they find?
They found there was no way to predict an avalanche or its size. There was no pattern. Sometimes, the avalanches would be small, sometimes large. It seemed any grain of sand could trigger an avalanche at almost any time.
Buchanan writes:
[…] every avalanche, large or small, starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.
In other words, triggers are unpredictable. An avalanche can happen at any time.
Buchanan piles on more evidence of similar findings in a variety of fields to reach “the surprising conclusion that even the greatest of events have no special or exceptional causes.
This is hard for most people to swallow. They want a reason why something happened. They want to have a theory. But most things happen for reasons we don’t understand.

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Three Ways to Invest in a World Prone to Catastrophe

When the 1987 crash happened, I was 15 years old. I remember being intrigued by the whole thing, but not really understanding what was going on.
The mystery of the crash partly helped fuel my interest in finance – and stocks specifically.
In the ensuing 30 years, I’ve lived through many more market catastrophes. They’re never easy to get through. Here are three steps to help you:

  • Always invest carefully. I always chuckle when I hear people say, “Now is the time to be careful” – as if there is a time to be careless! You should always invest carefully in a portfolio of stocks in well-financed companies at good valuations with managers who have skin in the game.
  • Only invest with money you can afford to leave alone. The longer, the better, but I think three years is probably a minimum. If you can do without the money you invest for at least three years, then this horizon will help limit the risk of having to yank your money out at a bad price just because of some stock market calamity like a 1987. You can afford to wait for better prices.
  • Keep something in reserve. You want to have the ability to add to your favorites if the market gives you a chance to do so at great prices. You can’t take advantage of a 1987 if you have no money.

If you follow these three key points, you’ll get through better than most everyone else.
Regards,
Chris Mayer

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