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Smart Investing
Rewind 1987: the lessons 20 years on
 October 22, 2007
Robin Bowerman
Investors of a certain age and style all know where they were on October 20, 1987. It is a day seared into the memory banks of many people simply because of the dramatic way that our sharemarket went into free fall losing 25% in one day.
For those not there the bald numbers tell a dramatic story. The Australian sharemarket all ordinaries index closed October 19 at 2128. Overnight in New York the Dow Jones index shed 22% of its value or 508 points – the Americans talk about Black Monday while for us it was a Black Tuesday.
By the time a halt was called to trading on the Australian market on October 20 the index was down to 1596.
It was a market meltdown that travelled around the globe – albeit at a much slower pace than it would today – and it was interesting this week to conduct a straw poll of investors who lived through those tumultuous days. The question was simple – do you remember what triggered the crash?
Valuations were certainly high – plenty of people were predicting a correction – because the market had had a fast run up but it is hard to point to a single issue that led to the crash. There were some external macroeconomic issues – a widening US trade deficit and disputes between the US and Europe around foreign exchange rates and interest rates – but what most market insiders later blamed the rapid collapse on was something much simpler – programmed computer trading. This was the early days of the technology age in investing and computers were programmed to sell mindlessly once prices fell through predetermined levels. It was rather quaintly called “portfolio insurance”. Exchanges and investors around the world certainly learnt from that experience.
When you look at share market index charts today 1987 looks little more than a pause for breath during a long climb, hardly the event that has generated so much media coverage this week to mark its 20 year anniversary.
To have lived through it was educational and a number of investors this week mentioned how the experience of 1987 had made them better, albeit more cautious, investors.
So at a time when we are enjoying a strong market run - even with the US sub-prime mortgage credit crunch still unfolding – it is timely to remember the 1987 crash and remind ourselves of how quickly the world can change.
The lessons from 1987 are both simple and just as relevant today. Understand the level of risk you are taking. As investors in shares we are putting our capital at risk in the expectation of reward either in the form of price appreciation or dividends. Now if any market falls 20% in short time it is going to be painful but just how painful depends on your level of diversification across the other asset classes. The catchcry “cash is king” was never more relevant than in the wake of 1987.
The value of liquidity is a lesson well remembered – with some similarities with the recent troubles in the sub-prime mortgage issue. Liquidity on small, speculative stocks dried up. So you may have wanted to offload the riskier part of the portfolio but in reality the only things you could sell were large blue chip shares where buyers could still be found. Liquidity and the ability to sell is something we tend to take for granted in the good times and in sophisticated markets. But as the sub-prime issues shows liquidity can still dry up rapidly if the market feels it cannot price the risk.
Investors today are being offered more and more exotic and complex alternative investments – liquidity and the age-old test of understanding what you are buying are just as valid filters as they were in 1987.
But perhaps the most important lesson of the 1987 crash is the value of time. The US market had regained all the ground in a relatively short time while our market languished much longer and it was not until May 1993 that it was back to the levels of September 1987.
But recover it did and since then investors have been well rewarded. Consider the case of someone who invested $10,000 into the Australian market index in June 1987 – just before the crash. They certainly would not have enjoyed October but 20 years later at June 2007 the value of their investment was $81,022.
Broad diversification and time: two things that help keep events like October 1987 in a proper perspective.
More articles from this week's CompareShares newsletter:
Analysis: Market crash signals
Markets: Local market to drop on memories of '87
Stock picks for the long haul: Mineral Resources (MIN) and The MAC Services Group (MSL)
Election: Who should win on November 24?
Smart Investing: Rewind 1987: the lessons 20 years on
Markets: US market plunges on crash anniversary
Resident Trader: How to profit from volatility - part 2
Trading: Learn from the Barings Bank rogue trader's mistakes
Stock of the week: Malachite Resources NL
Expert Panel: Trading international shares using CFDs
Commodities: Raging oil bull feeds euphoria
Superannuation: Buying your dream home in your DIY fund
Expert Panel: Why buy an instalment warrant instead of a share
Whatever your views, you can discuss this article - or any of Robin's articles - on our message board Your 2 Cents.
Robin Bowerman is Head of Retail at index fund manager Vanguard Investments Australia and the former managing editor of Shares and Personal Investor magazines. To receive this column by email each week go to http://www.vanguard.com.au/ and register with smart investing.
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