Is the Recent Financial Crisis Really a “Once-in-a-Century” Event?

Guofu Zhou and Yingzi Zhu

Financial Analysts Journal, 2010, vol. 66, issue 1, 24-27

Abstract: On 9 October 2007, the Dow Jones Industrial Average reached a high of 14,164.53; by 9 March 2009, it had dropped about 54 percent, to a low of 6,547.05. Former Fed chairman Alan Greenspan called this a “once-in-a-century” crisis. The authors show that the probability of a stock market drop of 50 percent from a high is about 90 percent over a 100-year period, based on the popular random walk model of stock prices. With a broad market index and a more sophisticated asset pricing model that captures more risks in the economy, the probability rises to above 99 percent. A market drop of 50 percent or more is very likely in long-term stock market investments, and investors should be prepared for it.During the recent financial crisis, the Dow Jones Industrial Average (DJIA) dropped about 54 percent, from a high of 14,164.53 on 9 October 2007 to a low of 6,547.05 on 9 March 2009. Former Fed chairman Alan Greenspan called this a “once-in-a century” crisis. In this article, we examine this claim.We used the drawdown probability to measure the likelihood of the occurrence of a crisis with a given magnitude. Based on the assumptions of the random walk model for the DJIA, we calibrated the long-term mean and volatility to the data and found that the drawdown probability for the Dow to drop more than 50 percent from a high is about 90 percent over a 100-year period. The result, however, is sensitive to our estimates of the long-term mean and volatility. With a broad market index and a more sophisticated asset pricing model that captures more risks in the economy, the probability rises to above 99 percent. The probability of a crisis can accumulate over a time horizon, which has a significant impact on long-run investments. Although the expected value of long-run investments grows over time, so does the probability of seeing a large swing of a fixed size. Over a 100-year period, the probability of a crisis can be very large.In terms of investing in the stock market, long-term investors should have prepared for a market drop of more than 50 percent. Based on both simple and complex asset pricing models, such a rare event indeed has a high probability of occurring in a 100-year period (although just a small probability in a given year). In 100 years’ time, such an event is almost certain to occur, and investors should be prepared for it.

Date: 2010
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DOI: 10.2469/faj.v66.n1.1

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