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'Black Monday' remembered 20 years later

Strategy, and a little luck, let Kellogg investors weather the 1987 market crash.

By Rebecca Lindell

It's remembered as "Black Monday," a dark day indeed for investors.

On Oct. 19, 1987, the Dow Jones plunged 508 points, losing 22.6 percent of its value. In one day, $500 billion disappeared from investors' portfolios. Markets around the world tumbled.

"People were pretty shell-shocked that day," remembers Robert Korajczyk, the Harry G. Guthmann Distinguished Professor of Finance. "Many faculty members were wondering if we were entering into the equivalent of the Great Depression."

Experts still cannot settle on one main cause for the crash. Program trading took much of the blame, while others pointed to panic selling, overvaluation and illiquidity.

"You can come up with lots of explanations ex post facto, but it's not always clear why something like this happens," Korajczyk says. 

In hindsight, he adds, the market overreacted. But while most portfolios took a big hit, all was not so bleak for a few investors. In fact, within weeks, members of the Kellogg School's student-run Portfolio Management Club had reason to feel downright cheerful.

The club began in 1987 with a stock portfolio valued at $33,000. By the end of November, the portfolio was worth about $40,000 — a gain of about 18 percent.

Professor Robert Korajczyk  
Professor Robert Korajczyk  
David Garrity '88  
David Garrity '88  

Club members credited the results to "a combination of dumb luck and conservatism," as chairwoman Anne Wieboldt '89 noted at the time. But their modesty couldn't obscure the fact that the group had made some smart defensive moves. Thanks in part to their prudence, the fund was positioned for healthy gains in subsequent years. As of Oct. 8, 2007, its value stood at $353,643.

A month before the 1987 crash, the club had sold a portion of its stock — a typical move each September that provided new members with fresh capital for new investments.

But the market's pre-crash volatility had led the club to reallocate its portfolio to 60 percent cash, instead of its usual summer position of 75 percent stocks and 25 percent cash. The market had peaked in August and equities were valued at historical highs relative to fixed-income investments and earnings forecasts. Together, those elements justified a conservative stance, remembers David M. Garrity '88, a club officer.

As a result, the value of the club's portfolio fell "just" $5,000 on Black Monday, a cause for pause, to be sure. But by the end of that November the fund had recovered that amount and more. Few other fund managers could say the same.

For Garrity, it was a stark but simple lesson. "What did I learn from Black Monday? Two words: risk management," says Garrity, a chartered financial analyst and director of research at Dinosaur Securities LLC in New York and a frequent commentator on portfolio strategies for CNBC and other news outlets.

"I firmly believe that it was risk management and asset allocation that enabled us to preserve the fund's principal value and to allow the appreciation it enjoyed that year."

The strategy was not one Korajczyk, then the club's adviser, would have chosen, though he allowed the students to follow their own path. "If you're an equities manager, your mandate is to manage equities and be fully invested," he says. "I probably would not have recommended their strategy — and I would have been wrong, ex post."

Meanwhile, Garrity watched his classmates' reactions to the crash. "As the day went on, people were walking out in the middle of class, rushing back to the dorm to check the financial news," he recalls. "People started to give serious consideration to changing their career plans, saying 'If this is a taste of what life is going to be like on Wall Street, I don't think I like the heat!'"

In fact, just 9 percent of the Class of 1988 obtained jobs in investment banking, compared to 17 percent of the previous year's graduates, according to Career Management Center records. Not that there were many Wall Street jobs to choose from — many firms had responded to the crash by slashing payrolls and new positions.

"It was very interesting to see how people's risk aversion became greater in the weeks after the crash," Garrity says. "If nothing else, it reminded us of the importance of simple practices, like diversification and putting money aside for a rainy day."

The Kellogg investment club's fund was created in the mid 1960s with $4,000 from the late industrialist Henry Crown and bolstered in the 1970s with a similar amount from the Crown Foundation. It was conceived as a way for students to gain real portfolio management experience with real dollars.

Today the fund is still student managed, but through a Kellogg course called the Asset Management Practicum. The four-quarter, full-credit class allows students to manage about $2.7 million of the school's endowment portfolio.

The equity portion of the fund follows a value investing strategy that is based on the students' fundamental security analyses. The fund allows short and long positions and the use quantitative and derivative strategies with respect to the fundamental analyses.

"We have investment guidelines, but students are allowed some latitude in the exposures they choose to take on," says Korajczyk, who teaches the class.

Garrity is among many Kellogg alums who have used this experience to build a thriving financial-services career. He now manages a fund at Dinosaur that, as of Sept. 30, has enjoyed a 34.2 percent annualized total return against the S&P 500's comparable 17.6 percent return since its inception in March 2007. 

The endowment fund that he has managed since September 2004 also boasts strong returns: 19.2 percent total return to the S&P 500's comparable 13.2 percent over the same period.

Risk management and asset allocation continue to occupy Garrity's mind: "When the market is down, we're typically down 49 percent of the market decline, and that's without the use of any options," he says. "It's strictly securities selection."

Twenty years after the crash, Garrity views today's up-and-down market with equanimity. Yes, the current year has been volatile, but Garrity calls for some perspective. He notes that 1998, for example, with its recession in Asia, the sovereign debt default by Russia and the collapse and rescue of the Long-Term Capital Management hedge fund, saw twice the volatility of this year. And even that was a far cry from 1987, he says.

"I don't want to diminish the human aspects of the [current] subprime mortgage crisis," he adds. "But just looking at it from a volatility standpoint, it's not anywhere as extreme."

Garrity notes that central bankers worldwide "acquitted themselves quite well" earlier this year when they injected billions of dollars into the global banking system in response to panic selling prompted by the crisis. The move helped calm a jittery market and quell fears of a broader economic meltdown.

The dollar's weakness remains a concern, however, and Garrity's advice for investors is rooted in the lessons he learned as at Kellogg. "If you want to be diversified, be diversified on a global level," he says. "Don't be dollar dependent. It's all about risk management."

Indeed, it always was.

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