The 1987 Crash and Portfolio Insurance

What you will learn

• The facts of Black Monday, 19 October 1987, in the United States and worldwide.
• How portfolio insurance and the related constant proportion method decide how much to sell as prices fall.
• How many investors following the same selling rule can create a feedback loop.
• Why a large overnight or one-day gap can push a "protected" portfolio below its floor.

Explanation

What happened

The Dow had risen from 776 points in August 1982 to a peak of 2,722 on 25 August 1987, a gain of about 44% for 1987 at that point. In mid-October, worries about rising interest rates, the US trade deficit and a weak dollar caused heavy selling; on Friday 16 October the Dow fell 4.6% to 2,246.74. On Monday 19 October it fell 508 points, or 22.6%, to 1,738.74, its largest one-day percentage fall ever. The S&P 500, an index of 500 large US companies, fell about 20.4%. All 23 major world markets fell sharply that month; the UK's FTSE 100 fell 23% in two days, and Hong Kong lost about 46%.

The economy did not collapse. On 20 October the Federal Reserve announced its "readiness to serve as a source of liquidity", lowered short-term rates and encouraged banks to keep lending to securities firms. The Dow ended 1987 slightly above where it began the year and regained its pre-crash peak by September 1989. After the crash, the New York Stock Exchange introduced trading halts after very large falls (circuit breakers) in 1988; how such halts work today is covered in the course "Order Books, Liquidity & How Orders Are Filled".

Portfolio insurance

A protective put (an option that gives the right to sell at a fixed price; see the Derivatives course) puts a floor under a portfolio. In the early 1980s, the academics Hayne Leland and Mark Rubinstein developed a way to copy that protection without buying options: dynamic hedging. The manager keeps a changing share of the portfolio in stocks and moves it according to a formula: sell stocks (in practice, sell stock index futures) as prices fall, buy them back as prices rise.

A simple version used in this lesson is constant proportion portfolio insurance (CPPI):

• Floor (F): the minimum value you want to protect.
• Cushion (C): portfolio value V minus floor F.
• Multiplier (m): how aggressively the cushion is used.
• Stock exposure = m × C; the rest is held in cash or bonds.

Why it can amplify a crash

Each fall in prices lowers the cushion, which requires more selling. If many large funds follow similar rules, their selling pushes prices further down, which triggers the next round of selling: a feedback loop. On 19 October many stocks opened late, so futures prices fell below the calculated value of the index, adding confusion about the "true" price. The official Brady Report (1988) described portfolio insurance as a factor that compounded the decline rather than its first cause; Leland himself argued its effect was probably small. Historians still disagree about how large the effect was, but the mechanism is clear.

Worked example

Hypothetical example: portfolio value €100,000, floor €80,000, multiplier 4. Costs, interest on cash and dividends are excluded; rebalancing happens at the end of each day.

Start: cushion = 100,000 − 80,000 = €20,000. Stock exposure = 4 × 20,000 = €80,000; cash €20,000.

After two 10% falls, the strategy has sold €38,400 of stocks into a falling market, exactly the behaviour that adds selling pressure.

The gap problem. Now suppose instead that the market falls 22% in one day before any rebalancing. Loss = 0.22 × 80,000 = €17,600, so V = €82,400, just above the floor. With a multiplier of 5 (stock exposure €100,000), the same fall loses €22,000 and V = €78,000, below the floor. The largest single fall the floor survives is 1 ÷ m: 25% for m = 4, 20% for m = 5. The protection assumes you can always trade in small steps; a gap breaks that assumption.

Common mistake

Practice activity

On paper: a hypothetical portfolio of €100,000 uses CPPI with a floor of €90,000 and a multiplier of 5. (a) How much is held in stocks at the start? (b) The market falls 8%. Calculate the new value, cushion, target stock exposure and the amount to sell. (c) What is the largest one-day fall, from the start, that keeps the portfolio at or above the floor without rebalancing?

Key takeaways

• On 19 October 1987 the Dow fell 22.6% in one day; it regained its peak by September 1989.
• Portfolio insurance copies a put option by selling as prices fall and buying as they rise.
• When many investors follow the same selling rule, the rule itself can deepen a fall.
• A strategy that needs continuous trading fails in gaps; under CPPI the floor survives a single fall of at most 1 ÷ multiplier.

Next step

The next lesson examines the dot-com bubble from 1995 to 2002, including Germany's Neuer Markt.