Can you imagine the U.S. equity market falling over 20% in one day?

It is easy for those that remember "Black Monday," which happened 30 years ago on October 19, 1987, when relentless waves of selling drove major equity indexes around the globe down 20%. The event was the culmination of what turned out to be a very sharp but very brief bear market. Confounding nearly every observer, then and still to this day, the crash did not amount to much in the broader economic context. Equity markets quickly regained their footing and vaulted to new highs through the 1990s amidst speculative excesses that made previous periods look demure.

But it is still hard to wrap our brain around a stock market drop of 20% in a single day, especially since it has been pretty much a one-way ride up since March 2009.

Check this out: there has been only a single instance of a daily stock market drop greater than 5% since 2009, as shown in the chart below. The top panel shows the daily price chart of the S&P 500 Index in green going back to 1977; the bottom panel shows the daily price change of the S&P 500 Index in orange over the same period. It’s crazy how much the drop in 1987 sticks out in terms of single-day events.

Those of us who were only in the eighth grade in October 1987 were less worried about the stock market falling and more worried about falling off a skateboard. However, like all serious investors, we are students of market and economic history and can't help but wonder if Black Monday could happen again. Our guess is that it can and will at some point in the future.

But don't take it from us … take it from Robert Schiller, winner of the economics Nobel prize in 2013, who took up the question in his great New York Times piece last week reflecting on his Black Monday conclusions:

 
Oct. 19, 1987, was one of the worst days in stock market history. Thirty years later, it would be comforting to believe it couldn’t happen again.
 
Yet that’s true only in the narrowest sense: Regulatory and technological change has made an exact repeat of that terrible day impossible. We are still at risk, however, because fundamentally, that market crash was a mass stampede set off through viral contagion.
 
That kind of panic can certainly happen again.
 

I base this sobering conclusion on my own research. (I won a Nobel Memorial Prize in Economic Sciences in 2013, partly for my work on the market impact of social psychology.) I sent out thousands of questionnaires to investors within four days of the 1987 crash, motivated by the belief that we will never understand such events unless we ask people for the reasons for their actions, and for the thoughts and emotions associated with them.

From this perspective, I believe a rough analogy for that 1987 market collapse can be found in another event — the panic of Aug. 28, 2016, at Los Angeles International Airport, when people believed erroneously that they were in grave danger. False reports of gunfire at the airport — in an era in which shootings in large crowds had already occurred — set some people running for the exits. Once the panic began, others ran, too.

That is essentially what I found to have happened 30 years ago in the stock market. By late in the afternoon of Oct. 19, the momentous nature of that day was already clear: The stock market had fallen more than 20 percent. It was the biggest one-day drop, in percentage terms, in the annals of the modern American market."

 

As investors, you must expect big drawdowns in the equity market because that is the nature of the ride on which we are embarking when we invest in equities. Nothing is going to change that, and nothing can control when it may happen again.

What you can control is what you do before it happens and when it happens.

Before it happens, the right asset allocation — your mix of equity, fixed income and diversifying alternatives — can help you meet long-term wealth planning goals while cushioning the inevitable jarring equity market drawdowns. And when those drawdowns rear their ugly heads, you can control how you act by not giving into the panic and selling at the bottom.

One of the best takeaways from the above chart is the opportunity cost of selling each time the equity market has bottomed over the last 40 years!

 

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