In a nutshell, one of the big reasons behind market selloffs is that investors and speculators are often leveraged (i.e. they have borrowed money to buy shares). Leverage magnifies gains on the way up, but it also magnifies losses on the way down.
Because the stocks owned are collateral against borrowed funds, an initial fall in the value of those securities (the initial selling) leads investors to have to put up more collateral (margin), leading to more selling. If they are unable to meet this "margin call," their brokerage will most likely close out their positions, leading to more selling. This cascading combination of effects exacerbates the selling even further.
A related concept to this is portfolio insurance. Portfolio insurance is widely believed to have been the driving factor behind Black Monday in1987, and understanding the dynamics of this component of the sell-off can help investors deepen their understanding of market crashes.
What is portfolio insurance?
In simple terms, portfolio insurance is a hedging strategy that limits an investor’s losses during market downturns by selling short stock market index futures. So if you own a portfolio of U.S. stocks and they start to go down in value, you would sell the S&P 500 and offset some of those losses. Although cleverly labelled "insurance," it is not an insurance policy in the proper sense; there are no premium payments, and no company will pay you if the market crashes.
This idea gained widespread popularity in the mid 1980s. In the run-up to the 1987 market crash, many investors adopted portfolio insurance, with the following parameters: if the market went down by 3% in a day, they would begin selling index futures to offset any losses after that point, and repurchase the futures if the market recovered. Of course, this stops being a good strategy if the market bounces around from day to day with 3% price swings. But that’s only a small problem that affects every given investor on their own.
Black Monday
The far bigger problem is what happens when a large portion of the market adopts such a strategy. On Black Monday 1987, selling in the stock market prompted investors to short the market in an attempt to offset their losses. Of course, the index is just composed of individual stocks, so this selling caused the individual stocks to drop even more.
This, in turn, prompted more automated insurance selling. This historical episode neatly showcases the problems with having automated loss-limiting systems, and also demonstrates how contagious panic can be. Although this specific type of loss limitation became discredited after the 1987 market crash, I am sure that we will continue seeing similar strategies in the future.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Seth Klarman: Why It Is So Hard to Have a Long-Term Perspective
- Howard Marks; The Federal Reserve Shouldn't Encourage Bad Behavior
- Seth Klarman: What Junk Bonds Can Tell Us About Value Investing
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