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Understanding Stock Market Crashes: Lessons from the Past and Strategies for the Future

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Charles M. Hall

October 18, 2023

Lower Chances of a Comparable Decline

Fortunately, the chances of witnessing a similar single-day decline in the U.S. stock market in the next few months are significantly low.

However, it is important to note that these odds, although low on any given day, are not zero. There remains a possibility that a drastic drop of this magnitude will occur someday. It is crucial for investors to take these odds into consideration when devising portfolio strategies, whether independently or with the assistance of a financial advisor.

Predicting Crash Frequency

Through extensive research conducted several years ago, experts developed a formula that successfully predicts the average frequency of stock market crashes over extended periods.

According to this formula, there is a one-in-five chance that within the next 30 years, the U.S. market will witness another 22.6% one-day drop.

The Unpredictability of Crashes

Taleb argues that daily stock market changes do not neatly fit into a bell-shaped or "normal" distribution, with minor changes forming the central hump and significant gains and losses on the tails of the distribution. Instead, the left tail of this distribution is thicker than anticipated, containing what Taleb refers to as "Black Swans."

Introduction

When it comes to managing portfolio risk, both investors and financial advisers often make a crucial mistake. They mistakenly believe that by lowering the risk, they can proportionally reduce the returns. However, due to the unpredictable nature of the stock market, this assumption is flawed. In fact, maintaining an "average" risk portfolio may result in below-average performance.

Illustrating with Examples

To better understand this strategy, let's consider an example. Imagine allocating 90% of your portfolio to one-year U.S. Treasury bills (BX:TMUBMUSD01Y) and using the remaining 10% to purchase one-year call options on the S&P 500 (SPX). By doing so, even if the call options expire worthless, you won't lose any money because T-Bills currently yield more than 5%. However, if the S&P 500 experiences substantial growth and covers the option's premium, you'll end up turning a profit. And if the stock market experiences a sudden surge, you'll achieve an outsized return.

This is just one approach among many. Another possibility is to allocate a significant portion of your portfolio to equities and use the remaining portion for S&P 500 put options. Regardless of the specific strategy, one thing is certain: by adopting this approach, you'll be able to sleep better at night.

Conclusion

In summary, it's crucial to reconsider the conventional approach to managing portfolio risk. Instead of aiming for an average risk level, investors and advisers should embrace hyper-conservatism and hyper-aggression. By allocating a significant portion to low-risk instruments and dedicating a smaller portion to highly speculative bets, individuals can better navigate the unpredictable nature of the stock market.