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30 Years Ago: Lessons From the 1987 Stock Market Crash

Debbie Carlson

Stock markets are sitting at record highs now, but 30 years ago, Wall Street suffered its biggest crash ever. On Oct. 19, 1987, the Dow Jones industrial average lost 22.6 percent of its value in a single day, a percentage drop twice as much as any single day in the 1929 stock market crash. Because of its severity, Black Monday stands out even for people who don't follow financial markets regularly.

It wasn't just a one-day event, though. Less remembered is the week preceding the crash, when the Dow lost 11.5 percent in three days, the biggest three-day drop since May 1940, when Germany invaded France, says Jay Sukits, finance professor at the University of Pittsburgh's Joseph M. Katz Graduate School of Business.

[See: 10 Tips for Keeping a Cool Head in a Market Meltdown.]

Scholars are still debating the exact cause of the crash, but 30 years later, financial market experts see enough similarities with today's market to make the lessons learned from the '87 crash relevant.

How Black Monday unfolded. Market participants were already worried before the Dow opened that Monday, says Sukits, who worked at Smith Barney at the time. "I was standing in a train station with a friend of mine that morning, and we were talking to one another, saying, 'Man, this is pretty frightening,'" he says. "I think that everybody who worked on Wall Street knows where they were on that day."

A few factors came together to trigger the crash. Many blame a momentum-based trading strategy called portfolio insurance, says John Longo, professor at Rutgers Business School and author of "The Art of Investing: Lessons from History's Greatest Traders." This strategy prompts investors to sell as prices fall, but although portfolio insurance played a role, Longo notes the market also was at a high before the crash, with stocks up roughly 40 percent at their intra-year peak before the crash.

This was also a busy time for mergers and acquisitions, which many blamed for job losses. Members of Congress in the powerful House Ways and Means Committee proposed legislation to make leveraged buyouts no longer tax deductible, which would likely have killed the deals, says Scott Nations, president of NationsShares and author of "A History of the United States in Five Crashes."

The straw that may have broken the camel's back was that bond yields for 30-year U.S. Treasurys had just risen to 10 percent. Earlier that week, then-Treasury Secretary James Baker had remarked that the U.S. should devalue the dollar to counter a record trade deficit, and Iran attacked a U.S.-flagged oil tanker in the Persian Gulf. "We thought we were finally at war with Iran," Nations says. "So, if you are worried about the stock market because of what it had done the week before, and now you think we're also at war with Iran, what do you do? You sell."

[See: 9 Ways to Invest in America With Bond Funds.]

What we've learned since then. Investors today can be forgiven if they're anxious about market crashes, given that memories of the last one less than a decade ago are still fresh in everyone's minds. But stock market crashes are rare events, historically coming many decades apart. "The market will crash again," Nations says. "That's not a reason to not invest. Some of the worst damage done is when it scares people away and they don't invest."

Crashes also sometimes prompt changes that can help limit the damage of future market crashes.

For instance, the biggest change to come out of the 1987 crash was the invention of circuit breakers, which stop trading when prices fall past a certain point. The first circuit breaker kicks in when there's a 7 percent decline in the Standard & Poor's 500 index, and trading is stopped for 15 minutes, Longo says.

"It helps avoid a panic scenario where people are selling just for the sake of selling," he says, noting that thanks to several levels of circuit breakers, it's unlikely that the stock market will experience another 22 percent drop in one day.

Along with those safeguards, the 1987 crash also left behind a legacy of lessons learned, and applying some of them to the market today isn't hard to do, given certain similarities. One of the biggest similarities between 1987 and now is how both markets are richly valued. When the stock market is strong, much like it is today, current events can be a breaking point, Sukits says, and considering how quickly news travels now and gets embedded in share prices, investors should keep that in mind as a potential trigger for plummeting stock prices.

Although portfolio insurance as a strategy was discarded, some critics of exchange-traded funds say that because these passive investing vehicles contributed to rising stock-market valuations, ETFs could exacerbate a market crash if everyone sells. Not necessarily, Longo says. A market correction could cause ETF holders to panic-sell, but unlike portfolio insurance, there is no automated rule that forces ETF selling, which is a big difference, he says.

That brings Longo to his next point -- the market eventually bounces back, just as it did after 1987, but it helps not to be overextended in whatever Wall Street's latest darling happens to be. "Another lesson is not to chase performance, either with hot stocks or hot funds, because the stocks that are most likely to fall severely are those that went up the most," Longo says. "So get back to basics and buy stocks with long-term history that pay a dividend."

[See: 10 Dividend Stocks Boasting 100 Years of Payouts.]

To that end, Chris Hyzy, chief investment officer for the global wealth and investment management division at Bank of America, adds: "The single most prominent lesson is [having] a diversified equity portfolio," he says. "Even if you're fully invested in the equity markets but you're diversified, time is in your favor."

In fact, 30 years ago, investors didn't have to wait long for their portfolios to recover. As Hyzy points out, "By the end of '87 the downdraft was completely wiped away."

Debbie Carlson has more than 20 years experience as a journalist and has had bylines in Barron's, The Wall Street Journal, the Chicago Tribune, The Guardian, and other publications. Follow her on Twitter at @debbiecarlson1.