Morningstar - Q2 2020 - 46

Spotlight: Market Crashes

two of its best-known proponents were Ludwig
von Mises and Nobel laureate Friedrich Hayek.

offering conflicting views. Such is the state of
knowledge in our industry.

The Austrians developed their own theory of the
business cycle. Like the Monetarists, the Austrians
blame the business cycle on the intervention
of the central bank on the economy, but for the
opposite reason. The Austrians believe that a
monetary expansion in a fractional banking system
causes an overexpansion of credit, leading
businesses to overinvest and misallocate resources.
Eventually, there is a correction, which leads to a
recession. Once the correction runs its course,
things go back to normal, until the next monetary
overexpansion.

Nevertheless, investors shouldn't throw away the
standard ways of summarizing risk. Instead, they
should understand both the limitations of standard
models and the ramifications of Mandelbrot's
insights. Instead of relying on summary statistics
to characterize the risks of investing in stocks,
investors should consider a more complete risk
model that tackles three questions:
gHow likely might a decline occur?
gHow long might it last?
gHow bad might it get?

Markowitz, H. M. 1952. "Portfolio Selection." Journal
of Finance, 7.
Markowitz. H. M. 1959. Portfolio Selection: Efficient
Diversification of Investments. New York: John Wiley
& Sons.
Minsky, H. P. 1986. Stabilizing an Unstable Economy.
New Haven, Conn.: Yale University Press.
Minsky, H. P. 1992. "The Financial Instability Hypothesis."
The Jerome Levy Economics Institute of Bard College,
Working Paper No. 74 (May).
Morningstar, Inc. 2011. "Morningstar Asset Allocation
Optimization Methodology." Morningstar Methodology
Paper, September.
Muth, J. F. 1961. "Rational Expectations and the Theory
of Price Movements." Econometrica, 29 (3).
Ross, S. A. 1976. "The Arbitrage Theory of Capital Asset
Pricing." Journal of Economic Theory, 13 (3).

Post-Keynesian
The post-Keynesian school seeks to remain
close to Keynes' General Theory, yet it
has produced some innovations, notably Hyman
Minsky's "Financial Instability Hypothesis"
(1986, 1992).

As I've shown in this article and the previous one
on black turkeys, downturns are numerous
and can be long and painful. Investors who are
prepared for these events will be better
able to endure the crisis and benefit from the
inevitable recovery. K

Minsky argued that market stability
is self-destructing because market participants
come to believe that markets will remain
stable, causing them to underestimate risk. Their
overoptimism sets things up for an inevitable
crisis. Once the crisis is resolved, the markets
become calm again, which starts the process
again that leads to the next crisis.

Paul D. Kaplan, Ph.D., CFA, is director of research with
Morningstar Canada. He is a member of the editorial board
of Morningstar magazine.

Sharpe, W. F. 1964. "Capital Asset Prices: A Theory
of Market Equilibrium under Conditions of Risk." Journal
of Finance, 19(3).

References
Cootner, P. H., ed. 1964. The Random Character of Stock
Market Prices. Cambridge, MA: MIT Press.

Xiong, J. X. 2010 "Nailing Down Risk." Morningstar Advisor,
February/March.

Of all of the business cycle theories that I have
summarized, Minsky's is the only one that
deals directly with the capital markets. It fits well
with the facts of the 2007-09 global financial
crisis and with the presence of black turkeys and
fat tails in global stock market historical
return data.
A Robust View of Risk
Like black turkeys, fat tails are everywhere in the
historical stock market return data. They're
prevalent not only in the U.S. and Canada, but also
in markets all over the world. Yet, these extreme
events do not exist in the standard statistical
models of finance.

As for explanations of them and the related
phenomenon of business cycles, we have a gaggle
of economists from various schools of thought

46

Morningstar Q2 2020

Friedman, M. 1968. "The Role of Monetary Policy."
American Economic Review, 58.
Friedman, M. & Schwartz, A.J. 1963. A Monetary
History of the United States, 1867-1960. Princeton
University Press.
Ibbotson, R. G. 2020. 2020 SBBI Yearbook: Stocks, Bonds,
Bills, and Inflation. Chicago: Duff & Phelps.
Kaplan, P. D., ed. 2012. Frontiers of Modern Asset Allocation.
Hoboken, N.J.: John Wiley & Sons.
Kaplan, P. D. 2015. "The Tails that Wag the Dog."
Morningstar Advisor, August/September.
Kaplan, P. D. 2018. "Filling in the Gaps." Morningstar,
August/September.
Kaplan, P. D. 2019. "Further Beyond the Bell Curve."
Morningstar, Spring.
Keynes, J. M. 1936. The General Theory of Employment,
Interest, and Money. New York: Harcourt Brace and Co.
Lintner, J. 1965. "The Valuation of Risk Assets and
the Selection of Risky Investments in Stock
Portfolios and Capital Budgets." Review of Economics
and Statistics, February.

Samuelson, P. A. 1948. Economics. McGraw-Hill Book Co.
Samuelson, P. A. & Nordhaus, W. D. 2009. Economics.
McGraw-Hill Book Education.
Satell, Greg. 2010. "Remembering Benoît Mandelbrot."
Kyiv Post, Oct. 19.
Morningstar - Q2 2020

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