10/19/1987: Lessons From the Stock Market's Black Monday

By Markets Fool.com

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The New York Times cover on Black Monday. Source: New York Times

On Black Monday, Oct. 19, 1987, the U.S. stock market suffered its largest one-day decline in history, as the Dow Jones Index fell by a staggering 22.6% in a single day of trading. What triggered this collapse? Can it happen again? What are the lessons for investors?

Financial meltdown on live TV
Black Monday can be described as the first truly global financial crisis, as collapsing stock prices started in Japan and extended west through Europe toward the United States. Although analysts have identified multiple possible causes for the crash, there was no unique explanation at the time.

From the beginning of the year to Black Monday, the Dow Jones was up by nearly 38%, so some analysts believe that excessive optimism and bubbly stock valuations set the stage for the crash. Also, computerized trading programs were gaining a lot of popularity at the time, and many programs sold futures contracts to protect portfolios when the market was falling. Exacerbated selling by these computer programs was identified as one of the main causes of the collapse.

Another major factor to consider is mass psychology and herd behavior. Global markets were already growing increasingly connected at the time, be it in technological, operational, or informational terms. Television was making it possible for traders around the world to watch collapsing stock prices in other corners of the planet via live TV, and this situation spread fear around the world in real time.

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"There is so much psychological togetherness that seems to have worked both on the up side and on the down side," said Andrew Grove, who was CEO of Intelat the time of the crash. "It's a little like a theater where someone yells: 'Fire!'"

Can it happen again?
Many important regulations changed after Black Monday, including new trade-clearing protocols and rules such as circuit breakers, which allow exchanges to halt trading temporarily in instances of exceptionally large price declines.

However, the financial world is more interconnected than ever in all relevant aspects, and the use of computerized trading has never been more widespread, with the rise of high-frequency trading and all kinds of complex quantitative strategies operating in multiple markets on a global scale.

Information flows at the speed of light via TV, news platforms, and even Twitter. Not only sophisticated professionals but any individual investor with access to an online trading platform can place trades in real time in all kinds of stocks, currencies, and derivatives markets.

More importantly, human emotions play a major role in these kinds of events, and history teaches us that we humans do not learn as much as we should from the error of our ways. In the words of Aldous Huxley, "That men do not learn very much from the lessons of history is the most important of all the lessons of history."

Stock prices are inherently unpredictable in the short-term. In the context of widespread panic and fear, almost anything can happen. Nobody knows what the future may bring, so the smart attitude for investors is to be ready for anything and expect the unexpected.

Some lessons from investors
An event like Black Monday can be truly jarring. However, things do not look that bad at all when looking at the market returns in perspective. The Dow Jones recovered all of its losses in a relatively short period, reaching new pre-crisis highs by the end of 1989.

^DJI Chart

^DJI data by YCharts

In retrospect, buying at the lows was the smart way to go. This is not cherry-picking a particular historical example, either, as every single major stock market decline in U.S. history has been a buying opportunity for investors with a longer investment horizon -- a trend that stretches from the Great Depression in 1929 to the subprime financial crisis in 2008.

When you are investing for the long-term, time is on your side, so you should capitalize on short-term volatility to make opportunistic purchases, as opposed to running away and selling at the worst possible moment.

For example, an investor who bought shares of big household names such as Coca-Cola, PepsiCo, and Procter & Gamblein October 1987 would be sitting on massive gains today. These are among the safest and best-known brands in the market, so these companies are typically considered low-risk investments.

KO Total Return Price Chart

Total Return Price data by YCharts

While Nikeis an undisputed market leader in sports apparel, the industry is extremely cyclical and competitive. Also, back in 1987, Nike did not have the enormous global presence it enjoys today, so it was a riskier choice.

Yet while Nike shares traded below $1 during Black Monday, it is now trading above $102 per share, generating stratospheric returns for investors who were smart enough to buy and hold when everyone else was frantically selling.

NKE Total Return Price Chart

NKE Total Return Price data by YCharts

History does not repeat itself, but it does rhyme. In times of widespread panic and fear, hunting for opportunities is a far better idea than running for the exits.

The article 10/19/1987: Lessons From the Stock Market's Black Monday originally appeared on Fool.com.

Andrs Cardenal owns shares of Apple. The Motley Fool recommends Apple, Coca-Cola, Intel, Nike, PepsiCo, Procter & Gamble, and Twitter. The Motley Fool owns shares of Apple, Nike, PepsiCo, and Twitter and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.