Black Monday
September 17, 2008

Stock prices sank sharply on Monday in the wake of Lehman Brothers' bankruptcy announcement over the weekend. Other firms perceived to have credit-related worries sank sharply as well: shares of insurance giant AIG fell 60.8%, Washington Mutual was down 26.7%, and Citigroup lost 15.1%. Among the thirty Dow Industrial component issues, only Coca-Cola managed to eke out a gain, closing up 25 cents for the day.

The S&P 500® Index fell 4.71%, its largest one-day percentage loss since September 17, 2001 when the Index fell 4.92% following a four-day trading suspension. Ranked by magnitude of one-day losses for the S&P 500® Index, Monday's decline ranks fourteenth among all trading sessions since January 1950. Although some market breaks are still fixed in our memory, others have faded from view. We suspect few non-professionals can recall what the news background was when stock prices plunged on October 27, 1997; January 8, 1988; or September 11, 1986.

Rank

Date

S&P 500®Close

Change vs. Prev Close

1

October 19, 1987

224.84

-20.47%

2

October 26, 1987

227.67

-8.28%

3

October 27, 1997

876.99

-6.87%

4

August 31, 1998

957.28

-6.80%

5

January 8, 1988

243.40

-6.77%

6

May 28, 1962

55.50

-6.68%

7

September 26, 1955

42.61

-6.62%

8

October 13, 1989

333.65

-3.12%

9

April 14, 2000

1,356.56

-5.83%

10

June 26, 1950

18.11

-5.38%

11

October 16, 1987

282.70

-5.16%

12

September 17, 2001

1,038.77

-4.92%

13

September 11, 1986

235.18

-4.81%

14

September 15, 2008

1,192.70

-4.71%

The S&P data are provided by Standard & Poor's Index Services Group.

Financial journalists will undoubtedly be scribbling energetically in the coming weeks to offer anxious investors an explanation for "what it all means." A sample appears in the most recent issue of Forbes, where three prominent investment professionals offer their views of the future: one is quite bullish, one is quite bearish, and the third is cautious but hopeful. Each offers compelling evidence to make their case. Forbes editors helpfully place each column on consecutive pages, making it easy for readers to determine which pundit is promoting views most similar to their own. The only investors likely to improve their portfolio results by reading such observations are those who were not properly diversified to begin with and become motivated to take action. The world is an uncertain place, and sharp fluctuations in asset prices reflect that uncertainty.

History offers abundant evidence that market economies are resilient. The world will find a way to manage its financial affairs without the advice of Lehman Brothers, and the residential mortgage loan will survive even if Fannie Mae does not. The key issue for investors is to make sure their financial future does not get derailed by events at a handful of firms, and that their portfolios are properly positioned to capture all the rewards the markets have to offer when the next up cycle begins. Recent events have provided an unusually harsh lesson of the importance of diversification. In a matter of days, shareholders of three financial giants—Fannie Mae, Freddie Mac, and Lehman Brothers Holdings—have seen their shares plunge into the penny-stock category. A fourth, American International Group, is scrambling for survival. For well-diversified investors, the financial damage associated with these four firms has been minor; in aggregate, they represented less than 1% of a diversified US equity portfolio on May 31, 2008, and even less for a global strategy.1 Four or five years from now, these investors may have a difficult time remembering what happened and when.

However, for those with concentrated positions, especially employees with large holdings of company stock, these events are a financial tornado inflicting potentially irreparable damage. One business owner cited by the Wall Street Journal recently purchased 25,000 shares of Freddie Mac at roughly $5 and lost most of his investment in a matter of days. Ironically, he claimed to be through with day-trading strategies, and was seeking a profitable long-term investment. Elsewhere, the Wall Street Journal estimated that the 24,000 employees of Lehman Brothers have seen $10 billion in personal wealth evaporate as the value of Lehman shares collapsed. Many long-time employees of Fannie Mae or Freddie Mac have experienced similarly catastrophic losses. When times are good, the risk of a concentrated portfolio often appears extremely remote. In March 2006, Fannie Mae was once characterized by Money magazine as "America's Safest Stock," with a bulletproof business model that was "as close as you'll get to an invincible earnings machine."

Events of 2008 demonstrate the importance of getting a few big issues right – namely diversification and balance.  We expect that patience will prove critical as well.

1Weights for the US Core Equity 1 Portfolio as of May 31, 2008 are used.

Bajaj, Vikas, Bajaj and Tara Bernard. "Worker Assets Shrink at Fannie and Freddie." New York Times, August 29, 2008.
Birger, Jon Birger. "The Rock." Money, December 2001.
Dreman, David. Dreman. "Get Ready for Rising Prices." Forbes, September 29, 2008.
Fisher, Ken Fisher. "The Unbubble." Forbes, September 29, 2008.
Karmin, Craig Karmin. "Small Fannie, Freddie Holders Take Issue With Washington." Wall Street Journal, September 12, 2008.
Karnitschnig, Matthew, Karnitschnig, Lian Leven, and Serena Ng. "AIG Faces Cash Crisis As Stock Dives 61%." Wall Street Journal, September 16, 2008.
Shilling, A. Gary Shilling. "Worse Is Yet to Come." Forbes, September 29, 2008.
Smith, Randall, Smith and Susanne Craig. "The Lehman Stock Slide Hits Home." Wall Street Journal, September 12, 2008.
Yahoo! Inc. Yahoo! Finance. In www.yahoo.com, accessed September 15, 2008.