On October 19 1987, the floor fell out from under world financial markets. The Dow Jones Industrial Average fell 508 points, or almost 23 per cent. “Black Monday”, as it has come to be known, remains the largest single-day market drop in history.
The culprit was a new kind of investment product known as portfolio insurance. Based on a mathematical model for pricing options, portfolio insurance consisted of a strategy of selling stock market index futures short while buying other equities. According to the Black-Scholes model, an event such as Black Monday could not happen. It was so unlikely it should not have occurred in the lifetime of the universe.
After the crash, investors screamed that the maths behind portfolio insurance had failed. And since then, history has repeated itself. After Long Term Capital Management imploded in 1997, the models were to blame. The 2007-08 crisis? Again the models. So, too, with the “London whale” fiasco that cost JPMorgan Chase upward of $6bn last year. The popular response is always the same. As Warren Buffett put it in 2009: “Beware of geeks bearing formulas.”