What did the crash teach us about the stock market? Plenty. The most vital lesson is this: A market dominated by big, sophisticated investors isn't more stable than one dominated by the proverbial "small guy."
The rise of big institutional investors -- pension funds, insurance companies and mutual funds -- is one of the best-established economic events of the postwar era. Until recently, it was widely viewed as a benign and boring development. No more. After the crash, it's clear that these big, shrewd investors are as prone to mob psychology as anyone else.
Grasp this reality, and you can appreciate the confusion created by all those post-crash reports. There's been an avalanche of them: from the presidential task force chaired by Nicholas F. Brady, from the stock and futures markets, and from government regulators. They haven't generated much excitement because they've focused on details of the crash -- a necessary job -- while skirting the main issue.
Government regulation of the stock market remains fixed in a bygone era when individual investors reigned supreme. But the market has fundamentally and permanently changed: The great pools of pension and insurance funds represent modern social necessities. They aren't about to vanish. The question raised by the crash is whether government regulation has to be overhauled -- and if so, how -- to accommodate these new investors.
Mob psychology didn't originate with institutional investors, but a mob of institutional investors is a powerful and dangerous one. When they make major changes in their portfolios, they have to buy or sell securities worth hundreds of millions, even billions, of dollars. "For the small investor, it's like being on a highway surrounded by 18-wheelers," says Samuel L. Hayes III of the Harvard Business School.
In hindsight, the stock market's huge rise in 1987 -- which defied all conventional methods of stock valuation -- may have reflected a herd buying instinct, just as the crash reflected a herd selling instinct. Unlike small investors, professional money managers constantly watch the latest economic and business news. They can buy or sell instantly, based on what they think the news means or what they think others will think it means.
So much mythology surrounds institutional investors that it's useful to separate fact from fiction:
Institutional investors don't own most stock. At the end of 1986, households owned 63 percent of the nearly $3 trillion worth of stock. Pension funds owned 21 percent and mutual funds 5 percent, with the rest held mainly by insurance companies, foreigners and brokers. Still, the rise of institutional ownership is impressive. In the early 1950s, households owned about 90 percent of the stock.
Where institutions dominate is trading -- buying and selling. Many pension funds turn over their portfolios once a year, says pension specialist William Bullion of SEI Corp. Trading by individuals accounts for about 25 percent of the total, down from 60 percent in the mid-1950s. Meanwhile, turnover on the New York Stock Exchange hit 73 percent in 1987: The equivalent of seven of every 10 shares on the exchange were sold. In 1980, turnover was only 36 percent; in 1965, it was 16 percent.
Institutional investors and other large investors also increasingly use a variety of sophisticated financial techniques to improve profits. These include stock options, stock index futures and trading strategies -- such as portfolio insurance and index arbitrage -- that require futures and options.
Despite all this frantic and complex trading, institutional investors -- on average -- may not do better than individuals. The small guy doesn't always lose. During the past five years, only a third of pension funds have performed as well as the Standard & Poor's index of 500 stocks. During the crash, only a third of pension funds lost less than the market.
The explosion of institutional trading has transformed the business of brokers and investment bankers. They have become big traders themselves, buying and selling from institutions in the hope of profiting from quick swings in prices. In 1986, revenues from trading accounted for 25 percent of the total for the securities industry, up from 8 percent in 1973.
What emerges is a faddish, erratic market, heavily driven by short-term trading. Price swings have become more volatile. Until recently, this increased volatility was attributed primarily to increased economic instability and uncertainty. But now it's clear that the changed nature of the market itself -- the greater turnover, the more frantic trading -- must share some of the blame.
Ever since the 1930s, when Congress created the Securities and Exchange Commission, the main aim of federal regulation has been to protect small investors. The SEC policed dishonest trading practices. Companies had to meet strict financial disclosure requirements. These remain worthy goals, but now government also should focus more on the market's stability.
Some needed changes are clear. Capital requirements for brokers and investment bankers should be raised. Capital -- the difference between what a firm owns and what it owes -- is a cushion of safety against losses. All financial markets have become riskier; trading in bonds and foreign exchange has also become more volatile. Yet the capital cushion has grown thinner. In 1971, capital represented 17 percent of the securities industry's assets; by 1986, that had dropped to 6.6 percent.
Regulation of the stock market and stock index futures -- traded on futures markets -- should also be centralized. Now the SEC watches the stock market, while the Commodity Futures Trading Commission watches the futures markets. The two markets are economically inseparable, as the Brady Commission argued. Divided responsibility creates confusion that, during a crisis, could be disastrous. The SEC should oversee both markets.
What else needs to be done? It's not clear. As Congress explores these issues, it's worth remembering that we're in a discovery process. We're learning how the new market operates: the answer isn't to make regulation suffocating, but to bring it up to date.