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Investment Lessons from the Challenger Disaster

25th October, 2020

Published in the Sunday Times on 26th October 2020

At 11:38 am on January 28, 1986, the space shuttle Challenger lifted off from its launch pad at Cape Canaveral. Seventy-four seconds later, it was ten miles high and rising. “Challenger go with throttle up” were the last words from the pilot before it blew up.

A superb documentary on Netflix chronicles the events, leading up to and in the aftermath of the disaster. The launch was televised, so news of the accident spread quickly. At first no one knew what happened.  Weeks of speculation followed, with rumours that a flame on the solid booster rocket may have been the cause. President Reagan established a commission to investigate the disaster, including such luminaries as Neil Armstrong and Nobel prize winning physicist Richard Feynman.

On June 6, 1986, more than five months later, the commission concluded that the explosion was caused by the failure of the Shuttle’s now infamous O-rings on the right solid fuel booster rocket. The company responsible, Morton Thiokol, one of four NASA contractors, was singled out for blame.

Stock Market Response

Stock markets are merciless in how they react to news. How long did it take for the market to process the explosion and incorporate it into the stock prices of the four NASA vendors? Days, weeks, months? In fact, the answer is measured in minutes.

By 11.52am on the day of the explosion investors started dumping the stocks of the four major contractors who had participated in the Challenger launch: Rockwell International, which built the shuttle and its main engines; Lockheed, which managed ground support; Martin Marietta, which manufactured the ship's external fuel tank; and Morton Thiokol, which built the solid-fuel booster rocket.

Twenty-one minutes after the explosion, Lockheed's stock was down 5 percent, Martin Marietta's was down 3 percent, and Rockwell was down 6 percent. Morton Thiokol's stock was hit hardest of all. As the finance professors Michael T. Maloney and J. Harold Mulherin report in a fascinating study of the market's reaction to the Challenger disaster, so many investors were trying to sell Thiokol stock that a trading halt was called almost immediately.

By the market close, Thiokol's stock was down nearly 12 percent. By contrast, the stocks of the three other firms started to creep back up, and by the end of the day their value had fallen only around 3 percent.

What this means is that the stock market had, almost immediately, labeled Morton Thiokol as the company that was responsible for the Challenger disaster.

As Maloney and Mulherin point out, though, on the day of the disaster there were no public comments singling out Thiokol as the guilty party. Regardless, the market was right. The O-rings that were supposed to prevent hot exhaust gases from escaping--became less resilient in cold weather, (and it was unusually cold in Florida that year) creating gaps that allowed the gases to leak out.

The wisdom of crowds

The stock market is a very efficient, arguably ruthless, discounting mechanism. This was a clear example of the wisdom of crowds and an exemplar of the theories that underpin financial markets, like efficient markets theory. This example should give any would-be investor that is attempting to outguess the market, pause for thought. So the market is always right. Or is it?

The madness of mobs

People can also be collectively unwise. The aftermath of our housing bubble just over a decade ago will remind you of that. In fact, the Nyberg report in 2011 on the causes of the Irish banking crisis identified a widespread belief in the efficiency of financial markets as a contributing factor. Numerous other investment bubbles are hard to square with the doctrine of market efficiency.

What are the implications of this for asset allocation?

The reason I bring this up today is, in the context of what efficient markets theory has to say about asset allocation, it has huge implications for the future of financial planning.

The efficient markets theory says that prices fully reflect all available information, so there’s no use trying to pick winners or losers or timing the market. You should just consider your own risk preferences, your age, your income, and the kind of retirement you’d like to have and then formulate your asset allocation to stocks and bonds to maximise your chances of achieving these goals.

Given our starting point today (for bonds at least), it would be safer to observe that there’s no guaranteed return on equities or bonds. Their performance depends on particular market conditions, and those conditions evolve over time. If your goal is to retire with a particular level of wealth, you need to manage your asset allocation dynamically. When equity markets have a higher expected return, you’ll want to tilt more toward equity markets; when equity markets have a lower expected return, you’ll tilt more toward bonds or other defensive assets.

Don’t be passive about your financial future

This is not an argument for being very active with your investments, rather it is an argument against being overly passive. As Massachusetts Institute of Technology professor Andrew Lo observes, markets are neither always efficient nor always irrational, but are adaptive.

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