October has historically been a volatile month for the U.S. stock market, notable for severe crashes in 1929 and 1987. While the probability of another crash in October 2024 is minimal, it is not impossible. The key takeaway for investors from past market turmoil is that significant one-day declines are an inherent part of investing, necessitating preparedness.
Market crashes, although rare, can happen multiple times within a generation. The "Black Swan" strategy, popularized by Nassim Taleb's book "The Black Swan: The Impact of the Highly Improbable," is relevant here. Black Swan events are sudden, terrifying, unpredictable, and extremely rare, and market crashes fit this description.
Examining the history of market crashes is crucial before discussing the Black Swan strategy. Twenty years ago, researchers derived a formula to predict the likelihood of single-day crashes over long periods. This formula was published in a 2003 issue of the journal "Nature." The prediction model, assuming a power-law distribution of crash probabilities, has proven effective in real-time scenarios. The model accurately forecasted a market drop similar to the 1929 crash within 21.4 years, which did occur on March 16, 2020, when the Dow Jones Industrial Average fell by 12.9%.
Harvard finance professor Xavier Gabaix, a primary author of the study, attributes unavoidable market crashes to large institutional investors' sudden withdrawal from stocks, which regulatory bodies cannot prevent. These investors use various methods, including derivatives and overseas markets, to reduce their stock exposure, rendering trading halts largely ineffective.
October, in particular, has shown to be a month of high volatility. While there is no definitive conclusion about why October appears prone to market crashes, historical patterns suggest heightened risk during this period. Gabaix speculates that crashes might be more likely when volatility is high.
Taleb recommends a "barbell" strategy to guard against Black Swan events. This involves being extremely conservative and highly aggressive simultaneously, rather than moderately aggressive or conservative. For instance, an all-equity portfolio allocates a small portion to long-term deep out-of-the-money index put options. These options often expire worthless but can yield substantial returns during Black Swan events.
Universa Investments, where Taleb serves as an advisor, exemplifies this strategy. During the 2000 market crash, media reports indicated its investment strategy had a year-to-date return exceeding 4000%.
