Online Class Notes (Michael C.)
Today we focused on:
General personal introductions, Tiktok, current geopoltical events and implications on business matters
Reading an article from martketwatch.com about 1987-style stock market crash
Speaking exercise
Thirty-six years ago, on Oct. 19, 1987, the U.S. stock market suffered its worst crash ever. That day, the Dow Jones Industrial AverageĀ DJIAĀ lost 22.6%.
The good news is that the odds are extremely low that U.S. stocks in the next several months will experience a comparable single-session decline.
The bad news is that those odds arenāt zero. Though the odds on any given day are low, chances are high that a drop of such magnitude will take place someday. Investors need to take those odds into account as they devise portfolio strategies, either on their own or with a financial adviserās help.
We know the odds of a crash becauseĀ researchers several years ago derived a formulaĀ that successfully predicts the average frequency of stock market crashes over long periods of time.
According to that formula, thereās a one-in-five chance that over the next 30 years the U.S. market will see another 22.6% one-day drop.
One way of judging the researchersā formula is by comparing the Dow Jones Industrial Averageās big drops over the past century with what that formula would have predicted. As you can see from the chart below, the formula has done an impressive job.
Insuring against a crash
To be sure, the researchersā formula doesnāt predict when crashes will occur, only their frequency over long periods of time. You might think that means you canāt plan for them. But that isnāt so, according to Nassim Taleb, a professor of Risk Engineering at New York University.
In his well-known book āBlack Swan: The Impact of the Highly Improbable,ā Taleb in effect argues that weāre wrong to think that daily stock market changes neatly fall into a bell-shaped or ānormalā distribution, with most of those changes being minor (the hump in the middle of the bell) and a few big gains and a few big losses in the right and left tails of that distribution. Instead, the left side of that distribution is fatter than expected; that fat tail contains what Taleb refers to as āBlack Swans.ā
Because stock market gains and losses donāt adhere to a normal distribution, both investors and financial advisers are mistaken in thinking they can simply lower clientsā portfolio risk and proportionally reduce their returns. Instead, an āaverageā risk portfolio will have below-average performance.
Taleb writes: ā[B]ecause of the Black Swan, [your strategy should be] ā¦ as hyper-conservative and hyper-aggressive as you can be instead of being mildly aggressive or conservative. Instead of putting your money in āmedium riskā investmentsā¦ , you need to put a portion, say 85 to 90 percent, in extremely safe instruments, like Treasury bills. ā¦ The remaining 10 to 15 percent you put in extremely speculative bets, as leveraged as possible (like options).ā
Thirty-six years ago, on Oct. 19, 1987, the U.S. stock market suffered its worst crash ever. That day, the Dow Jones Industrial AverageĀ DJIAĀ lost 22.6%.
The good news is that the odds are extremely low that U.S. stocks in the next several months will experience a comparable single-session decline.
The bad news is that those odds arenāt zero. Though the odds on any given day are low, chances are high that a drop of such magnitude will take place someday. Investors need to take those odds into account as they devise portfolio strategies, either on their own or with a financial adviserās help.
We know the odds of a crash becauseĀ researchers several years ago derived a formulaĀ that successfully predicts the average frequency of stock market crashes over long periods of time.
According to that formula, thereās a one-in-five chance that over the next 30 years the U.S. market will see another 22.6% one-day drop.
Need to Know:Ā Stanley Druckenmiller says central banks, not earnings, move markets. His axiom will be put to the test Thursday
One way of judging the researchersā formula is by comparing the Dow Jones Industrial Averageās big drops over the past century with what that formula would have predicted. As you can see from the chart below, the formula has done an impressive job.
Insuring against a crash
To be sure, the researchersā formula doesnāt predict when crashes will occur, only their frequency over long periods of time. You might think that means you canāt plan for them. But that isnāt so, according to Nassim Taleb, a professor of Risk Engineering at New York University.
In his well-known book āBlack Swan: The Impact of the Highly Improbable,ā Taleb in effect argues that weāre wrong to think that daily stock market changes neatly fall into a bell-shaped or ānormalā distribution, with most of those changes being minor (the hump in the middle of the bell) and a few big gains and a few big losses in the right and left tails of that distribution. Instead, the left side of that distribution is fatter than expected; that fat tail contains what Taleb refers to as āBlack Swans.ā
Because stock market gains and losses donāt adhere to a normal distribution, both investors and financial advisers are mistaken in thinking they can simply lower clientsā portfolio risk and proportionally reduce their returns. Instead, an āaverageā risk portfolio will have below-average performance.
Taleb writes: ā[B]ecause of the Black Swan, [your strategy should be] ā¦ as hyper-conservative and hyper-aggressive as you can be instead of being mildly aggressive or conservative. Instead of putting your money in āmedium riskā investmentsā¦ , you need to put a portion, say 85 to 90 percent, in extremely safe instruments, like Treasury bills. ā¦ The remaining 10 to 15 percent you put in extremely speculative bets, as leveraged as possible (like options).ā
To illustrate, imagine allocating 90% of your portfolio to one-year U.S. Treasury billsĀ BX:TMUBMUSD01YĀ and buying one-year call options on the S&P 500Ā SPXĀ with the remaining 10%. Since T-Bills currently yield more than 5%, you will not lose money over the next year even if the call options expire worthless. If instead the S&P 500 rises enough to pay for the optionās premium, you will turn a profit. And if the stock market skyrockets, you will realize an outsized return.
Thatās just one example. Another possibility is to substantially invest in equities and allocate the remainder to S&P 500 put options. Regardless, you will definitely sleep better for it.
Vocabulary
Pricing penetration – Is a pricing strategy where the price of a product is initially set low to rapidly reach a wide fraction of the market and initiate word of mouth.
Pessismistic (adj) – Tending to see the worst aspect of things or believe that the worst will happen.
Example: He was pessimistic about the outcome
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