A Computer Lesson Still Unlearned

It was just a quarter-century ago that Wall Street was shaken to its core by the Oct. 19, 1987, stock market crash.

On one day, the Dow Jones industrial average lost 23 percent of its value. People wondered if that heralded a new Depression. A front page headline in The New York Times asked, “Does 1987 Equal 1929?” It did not. The next recession, a mild one, was more than two years away.

What it did signify was the beginning of the destruction of markets by dumb computers. Or, to be fair to the computers, by computers programmed by fallible people and trusted by people who did not understand the computer programs’ limitations. As computers came in, human judgment went out. That process, then in its infancy, gained speed over the next two decades. By 2008, it really did threaten a new Depression. But we’ll get to that later.

The 1987 villain was something called portfolio insurance. It was a product that used stock index futures and options to assure institutional investors that they need not worry if market prices seemed to be unreasonably high. Portfolio insurance would let them get out with minimal damage if markets ever began to fall. They would simply sell ever-increasing numbers of futures contracts, a process known as dynamic hedging. The short position in futures contracts would then offset the losses caused by falls in the stocks they owned.

(Full read here). Photo courtesy Globe and Mail.