30 years after 1987 – how stock market crashes can make you a better investor

By the Prime Value investment team – October 2017

Nobody in the investment industry will enjoy remembering the 1987 stock market crash, 30 years ago this month, yet this event still holds many valuable lessons for investors.

Without wanting to frighten anyone, crashes are relatively common over history. At Prime Value, our team has experienced several crashes: Black Monday 1987 (which was actually “Black Tuesday” in Australia), the 1997 Asian Financial Crisis, the 2000 tech-wreck, the 2008 global financial crisis, and the “flash-crash” of 2010.

Even corrections of 10 per cent, which happen two or three times a year, will create anxiety.

1987 is special because of its sheer magnitude – unprecedented at the time, and thankfully yet to be repeated: the Australian stock market lost 25 per cent in a single day; Wall Street lost 23 per cent.

Experts still squabble about the reasons why, but investors are better off accepting that crashes tend to come as a surprise. They hit hard, and hit everyone.

Importantly, crashes remind us to take nothing for granted, which can make us better investors – here are just some ways crashes can be a positive influence:

  1. They remind us to consider the downside: Focussing on big returns is seductive, but without an ability to limit downside risk it counts for nought. There are many ways to limit downside risk, including stock selection – hence many managers spend more time looking at what can go wrong, rather than what might go right, before investing. Discipline in this area prevents you from choosing suspect stocks and being swept away by “irrational exuberance” regarding a certain stock or market.
  2. They teach us to handle leverage with care: Excess leverage happens before most major crashes – margin calls played a big role in 1987. Nothing exacerbates losses like borrowings. As you can never predict the next crash or downturn, it pays to be careful. This also applies to companies – just like investors, some stocks are drunk on borrowings, and they will fall the hardest. You need to appreciate the risks involved before buying.
  3. They remind us simple is good: From time-to-time the market will become excited by stocks which, on close inspection, make little sense. Overly complex corporate structures and revenue models are a warning sign. If it’s not easily understandable it won’t be easy to value – companies with labyrinthine structures are often among the hardest hit when everything goes south.
  4. They remind us to remove emotion from decision-making: The 1987 crash was so frightening many thought another great depression was on the way. Yet history shows stock markets worldwide eventually recovered well. Investment emotions are powerful – whether it’s fearing for the worst, or being greedy for more, they are not easy to control. Successful long-term investors will always go back to their strategy and their process, removing emotion from decision-making.
  5. They show quality can come back: We’re obsessed with finding quality stocks because not only do they have growth potential, they limit your downside risk and can recover well from setbacks. Thinking back to the 1987 crash, the ASX lost 25 per cent in one day. Some companies were devastated and never came back – we saw the same thing again during the GFC, where several high-profile stocks were delisted.
    Quality stocks will show balance sheet discipline, meaning they have little to no gearing, and are flush with cash. Not only do these stocks outperform in weak market conditions, which could be considered defensive, they are also well positioned to capitalise on cheaper prices by taking share from, or acquiring, weaker competitors.
  6. Crashes create buying opportunities: Investors could be forgiven for wanting to walk away after a big crash, but those with cool heads will find bargains among the wreckage. A market may crash, but there will always be good, easy to understand businesses, with strong balance sheets, good cashflows and good management. These will be cheaper following a crash, giving you a chance to make tomorrow’s big returns.

Prime Value’s investment team has over 100 years’ collective investment market experience

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