Opinion: Stock market’s volatile October history means it’s time to

Those odds don’t seem like much — but they are not zero. The Dow Jones Industrial Average
DJIA,
-1.04%
tumbled 22.6% on Oct. 19, 1987, Black Monday. An equivalent percentage drop from its current level would take more than 7,700 points off the Dow in a single trading day.

Few investors in the market nowadays remember the trauma of Black Monday. Those who do may reassure themselves that a similar crash couldn’t happen today, given market reforms that were instituted in the wake of the selloff.

They are kidding themselves, according to a study conducted by Xavier Gabaix, a professor of economics and finance at Harvard. He and his-coauthors derived a formula that predicts the frequency, over long periods of time, of large daily swings in the market. Upon testing the formula against hundreds of years of stock market returns in both the U.S. and around the world, they found the formula to be impressively accurate.

For example, Gabaix’s formula predicts that a 22.6% drop in the market will occur every 150 years, on average, over long periods of time. That doesn’t mean such a crash will occur every 150 years, since this predicted frequency is an average over extremely long periods. So the market could experience no such crash over a 150-year period, or experience two of them (or more).

What you can’t conclude, however, is that the odds of a crash are zero.

Why market reforms can’t prevent a crash

You might object to this conclusion on the grounds that market reforms instituted since 1987 will prevent another crash from occurring — circuit breakers, trading halts and other safeguards. But, as Gabaix has explained to me many times in interviews over the years, such reforms are powerless to prevent a crash. That’s because all markets are dominated by their largest investors, and when many of them want to get out of the market simultaneously, for whatever reason, the market will crash.

For example, even if trading halts and other restrictions succeed in preventing these large investors from selling on U.S. exchanges, they can still sell on foreign exchanges where many U.S. stocks also trade. They can also sell short with stock index futures contracts or via the purchase of put options. You’re kidding yourself if you think these large investors will be prevented from getting out if they want to.

Black swans

Gabaix’s research underlines why it’s so important to prepare for so-called black swan events like market crashes that are sudden, awful, unpredictable and rare. Notice that, by this definition, they are unpredictable, so it’s false comfort to…