On Oct. 19, 1987, the Dow Jones Industrial Index fell over 22% in the course of one trading day, with all major stock markets around the world being affected. In his 1987 letter to shareholders of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), Warren Buffett (Trades, Portfolio) performed a post-mortem of the crash and explained how retail investors could benefit from such events in the future.
A manic rampage
Buffett described the events of 1987 as a manic rampage by Mr. Market, followed by a sudden, massive seizure. Professional money managers had become divorced from market fundamentals and were too focused on trying to predict the actions of other market participants. This led to the widespread adoption of portfolio insurance:
"An extreme example of what their attitude leads to is 'portfolio insurance,' a money-management strategy that many leading investment advisors embraced in 1986-1987. This strategy - which is simply an exotically-labeled version of the small speculator's stop-loss order dictates that ever increasing portions of a stock portfolio, or their index-future equivalents, be sold as prices decline. The strategy says nothing else matters: A downtick of a given magnitude automatically produces a huge sell order. According to the Brady Report, $60 billion to $90 billion of equities were poised on this hair trigger in mid-October of 1987."
The merits of portfolio insurance for individual funds has been hotly debated. What is clear is that when adopted on a systemic level, the combined effect of so many players selling into the market, precipitating even more selling, was a disaster. For Buffett, the concept seemed ludicrous:
"If you've thought that investment advisors were hired to invest, you may be bewildered by this technique. After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighboring property was sold at a lower price? Or would you sell your house to whatever bidder was available at 9:31 on some morning merely because at 9:30 a similar house sold for less than it would have brought on the previous day?"
In this model, the less an asset is worth, the more heavily it should be sold. Conversely, the more expensive an asset, the more vigorously it should be purchased. This, of course, is the exact opposite of what value investing dictates, which is why it seems so strange to Buffett.
"Many commentators, however, have drawn an incorrect conclusion upon observing recent events: They are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys. This conclusion is dead wrong: Such markets are ideal for any investor - small or large - so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times."
Buffett ultimately believes that as long as large money managers are going to act in such ways (and they show no signs of stopping), there will always be mispricings the small retail investor can take advantage of.
Disclosure: The author owns no stocks mentioned.
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