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Buffett had a front row seat to observe the stock market crash of October 1987 following his purchase of Salomon preferred a month before. He was told by earnest mathophiles that they had got the “science” of investment sussed. They could see from analysing market movements and a raft of macro and company stock trading data where to place their bets. They had computer programmes selecting shares. And to protect the downside they wrote code instructing computers to automatically sell shares and futures contracts in shares if the market fell by more than a set percentage. Thus, they thought themselves insulated from any downturn.
But Buffett and Munger had seen this kind of over-confidence before. These people were not engaged in investment at all, as defined by Benjamin Graham. That is,
(a) a thorough understanding of the company,
(b) a margin of safety, and
(c) the expectation of merely reasonable returns.
It was the opposite, that shudder-making activity, speculation. We can see a result of that speculation in this chart. In just a few days the market fell 36% from its peak.
The Dow Jones Industrial Average August 1987 – January 1988
Buffett was scolding
“We have “professional” investors, those who manage many billions, to thank for most of this turmoil. Instead of focusing on what businesses will do in the years ahead, many prestigious money managers now focus on what they expect other money managers to do in the days ahead. For them, stocks are merely tokens in a game, like the thimble and flatiron in Monopoly.
“An extreme example of what their attitude leads to is “portfolio insurance,” a money-management strategy that many leading investment advisors embraced in 1986-1987. This strategy –
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