Lessons from the Great Crash of 2:45 P.M.

By Walter Updegrave, senior editor

(Money Magazine) -- Question: I was astounded at last week's plunge in the stock market and amazed how a keystroke error could create this much havoc. Surely there have to be built-in protections to prevent this type of error and its effects. How much money did investors lose? --Gary, Buffalo, New York

Answer: At this point it's still not clear what exactly took stock investors on a white-knuckle rollercoaster ride last Thursday.

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

At first, blame was placed on a possible "fat finger" trade, i.e., a klutzy trader hitting the wrong key on a computer. But now the thinking is that a disconnect between computerized trading systems and a New York Stock Exchange program that under certain circumstances slows down trading in individual shares may have played at least a supporting role in the mayhem.

No doubt the lack of a coordinated system of circuit breakers across different exchanges didn't help either.

But whatever initially spooked investors, there was clearly enough anxiety floating around about other concerns -- most notably the debt drama playing out in Greece and other European countries -- to drive the Dow down another 139 points the next day, leaving the index at Friday's close 50 points below where it started the year.

As for losses, well, based on the Wilshire 5000 index -- a good proxy for the U.S. stock market -- some $1.2 trillion in market value was vaporized from the high to the low on Thursday, although by the end of the day it had narrowed to a "mere" $500 billion.

That figure doesn't translate into actual realized losses for investors, though. For one thing, not all shareholders bailed during the panic. Those who hung on saw the Dow rally yesterday and climb back to within 141 points, or 1.3%, of Thursday's high on news that European officials approved a near $1 trillion debt rescue plan.

And even investors who did sell at or near Thursday's bottom may get a mulligan, as some transactions are being reversed. For example, Nasdaq canceled the trades of nearly 300 stocks that fluctuated the most.

I'll leave it to others to debate whether this incident calls for more regulation. The SEC met yesterday with officials from six stock exchanges to discuss the causes of last week's chaotic plunge and agreed on a framework for strengthening circuit breakers and dealing with erroneous trades.

And Congressman Paul Kanjorski, Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, announced he'll be holding a hearing at 3 p.m. today to "thoroughly investigate this situation and take action to ensure the integrity of the markets."

You can decide whether such meetings and investigations are cause for comfort or concern. In the meantime, though, I think last week's freefall provides some useful lessons you can apply to your future investing.

Rethink your risk tolerance

At the very least, this latest episode of yo-yo stock prices provided yet another stark reminder that stocks aren't the place for cash you'll need in the short term.

I'd recommend that even someone investing for the long run view last week's rout as a wake-up call to re-evaluate the risks of owning stocks. The reason is that in recent years a number of people have made a convincing case that the potential for cataclysmic setbacks and long-term losses in equities is much greater than many investors believe.

For example, in his 2007 book A Demon of Our Own Design, former hedge fund manager and current Securities and Exchange Commission adviser Richard Bookstaber warned that the spread of complex financial instruments like CDOs, credit swaps and such makes the markets more volatile and prone to periodic breakdowns. As the financial system reeled in 2008, I couldn't help but think back to a brief interview I did with him in which he all-but-laid out a template for the coming financial crisis before the you-know-what even hit the fan.

Recent research from Morningstar's Paul Kaplan and Ibbotson Associates' James Xiong also suggests that our traditional notions of stock risk need to be revised. Specifically, they contend that the traditional analysis advisers use to create portfolios understates the potential for outsize losses.

Their rationale is a tad technical, but basically boils down to two words: "fat tails," meaning that a graph of stock returns has more extreme highs and lows than the bell-shaped curve that advisers typically assume when creating portfolios. The implication: although hardly commonplace, big long-lasting declines in the market may not be as rare as we think.

I don't mean to suggest that investors should abandon equities. That would be foolish. Long-term investors can still reap attractive gains if they have the discipline to ride out -- and even buy -- during the market's periodic convulsions.

That said, you've got to be realistic about how much volatility is appropriate, particularly when you're tapping or are about to tap investments for retirement income. Alas, many older 401(k) participants may be investing far too aggressively for their own good.

Who knows, maybe the SEC confab and that Congressional hearing will get to the bottom of what happened last week and come up with a constructive response. But even if they do, stocks are still going to be highly volatile. That's the nature of the beast.

So if you take away anything from last week's adventure, let it be the resolve to properly factor the real risk of stocks into your investing decisions. To top of page

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