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Mark Hulbert
May 6, 2011, 12:01 a.m. EDT
By Mark Hulbert, MarketWatch
CHAPEL HILL, N.C. (MarketWatch) "” Last year's infamous "flash crash" was not a one-time event.
Another is certain to happen again.
That is perhaps the most important investment lesson we can draw on this anniversary of what happened one year ago, when the Dow Jones Industrial Average /quotes/comstock/10w!i:dji/delayed DJIA +0.43% , already down several hundred points for the day, dropped 600 more points in a matter of a few minutes. As we devise our portfolios and strategize about how to hedge risks, we must recognize that such huge drops are an inevitable feature of the investment landscape.
Unfortunately, given all the Monday-morning quarterbacking and regulatory hand-wringing that has taken place over the last year, we are being encouraged to think of such sudden drops as preventable. This is dangerous thinking, however, since it leaves us vulnerable to the inevitable.
These at least are the conclusions I drew from interviewing Xavier Gabaix, a finance professor at New York University. One of his areas of academic focus has been large fluctuations in the stock market. ( Click here for a copy of a paper he wrote on the subject, co-authored with H. Eugene Stanley, Parameswaran Gopikrishnan, and Vasiliki Plerou, each at Boston University. )
Prof. Gabaix and his colleagues derived a complex mathematical formula for predicting the frequency of large daily stock-market movements. Though they believe that their formula rests on a solid theoretical foundation, the proof of the pudding is in the eating.
So they tested their formula not just in the U.S. stock market but also in foreign stock markets as well as in the foreign exchange arena. Their formula worked in those other markets too.
How often, according to their formula, will a 10% daily drop occur "” approximately the magnitude of last year's Flash Crash? About once every 13 years or so, on average.
Why would the markets adhere to such a precise formula?
Because, Prof. Gabaix told me, of a universal trait of the investment world: Every market, to a more or less similar degree, is dominated by its largest investors. In this country, for example, the trades made by the large institutional investors are many orders of magnitude greater than any of ours.
And when those large investors together want to get out of stocks, the market will plunge. Yes, those institutional investors might have gotten spooked during last year's Flash Crash by an erroneous trade. But we're fooling ourselves if we think it's possible to legislate away the herd instinct among the largest investors, or to prevent them from ever being spooked again in the future.
The corollary? To the extent that the regulators' trading curbs and circuit breakers and the like have any effect, it will be merely to postpone the selling for a day or two.
If the researchers are right, regulators are tilting at windmills in trying to find ways of preventing the market from rapid dives. Investors would be far better served by recognizing that big price drops, though infrequent, are an unavoidable price to pay for being invested in the stock market "” and to design their financial plans accordingly.
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
"Mark Hulbert: Get ready for another flash crash http://on.mktw.net/k8YEGk" 11:25 p.m. EDT, May 5, 2011 from MktwHulbert
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Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD became a service of MarketWatch in April 2002. In addition to being a Senior Columnist for MarketWatch, Hulbert writes a monthly column for Barron's.com and a column on investment strategies for the Journal of the American Association of Individual Investors. A frequent guest on television and radio shows, you may have seen Hulbert on CNBC, Wall Street Week, or ABC's World News This Morning. Most recently, Dow Jones and MarketWatch launched a new weekly newsletter based on Hulbert's research, entitled Hulbert on Markets: What's Working Now.
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