Five Things We Can Learn From the Market Bust

This is a guest post by Dana. Dana writes for the Investoralist, a blog that explores the fundamental principles of successful investing, and provide meaningful discussion of the topic based on a holistic look at the macro-investing environment.

We are in a severe recession ‒ some say the worst since the Great Depression. For months, the global economy continues its death march, and the doomsday machine is turned on and cranked up. But the rational voices inside us know that one day, someday, we will see the other side again. The bear market will inevitably give away to the bull, and optimism will find its way back into the market. Knowing that, what can we learn from this recession?

1) Investing is an inherently risky activity.

That sounds like a redundant and simple enough statement. Most people understand the trade-off between risk and reward, and most of you reading this have lived long enough to see both bull and bear markets. Therefore, investing at the present time, just as in the past, and no doubt into the future, carry a certain degree of risk.

The tightly integrated global system greatly extends the influence of one nation’s domestic policies to places beyond its border. In the past twenty years, consumer, financial, and speculative activities in one country were shown to have far reaching consequences on not only its neighbours, but its trading partners. Look at large exporters like Germany, Japan, South Korea; or resource rich countries such as Canada and Australia. Through little faults or control of their own, exports of manufactured goods and resources have dropped significantly as a result of the (originally) American crisis. The idea of global decoupling has not held up, as experiences during the past few months signal an ever more tightly fused global economy. In good times, this bond facilitates the spread of prosperity. But in times like this, it can make an economic malaise impossible to contain.

For an invested individual in 2008, this meant an across-the-board onslaught of any carefully constructed portfolio. Diversification mattered little. Geographically, Asia, Europe, North America and Australia all suffered. Across most sectors, stocks stayed depressed. Little liquidity in the credit market and shaky economic prospects had all but decimated consumer and business confidence.

From a macroeconomic perspective, a lot of things happened in the market during this time. I will not dwell on the details, but let’s just say that quite unexpectedly: the US dollar got stronger, commodities got weaker, and banks went, well, bankrupt. Without a sincere appreciation and keen understanding of the inter-connectedness of global forces, it’s naïve and almost irresponsible to declare a company or sector healthy solely on its own merits.

That brings me back to the point: investing is a risky endeavor, and you need more than smartness and basic financial understanding to be consistently successful at it. If you can’t explain what happened during the past year, if you don’t have time to study your investments and stay on top of global political and economic news, or that you are not confident that you have a financial advisor that has the competency to perform all of the above, then perhaps it’s wise to re-consider the risk that you would like to take going forward.

2) Timing issues should concern an investor too.

I’m not talking about timing the market, although if you consistently buy high and sell low, that could be a problem. The timing issue is one that addresses your investment horizon and your financial obligations, the end goal being one that creates a good fit which maximizes your investment gains while meeting your financial needs at any given point in time.

In asset banking, they call this liquidity matching. There’s a whole sub-field in finance that specializes in matching appropriate short-term deposits with short-term loans, and long-term deposits with long-term loans. A mis-match in terms of assets versus liabilities has led many banks and credit unions to financial ruin.

In personal investing, liquidity matching should also be a key consideration. The most devastating tales of financial hardship come from retirees who are experiencing lower cash flows from a reduced capital base and unable to fund their expenses; or parents who cannot to recoup their children’s college funds in time for their enrollments.

Bottom line: be aware of your cash needs in the near future, and set those money aside (i.e. in safe investment vehicles). And if your have little revenue sources and your needs are ongoing, then be as conservative with your cash as possible.

3) Past performance is no indicator of future trends.

This is another commonly cited piece of wisdom in the investing world. It has been regurgitated time and again that examining a stock or mutual fund’s past glory is little indicator of its future performance.

When technology stocks were doubling every week during the late 90s; and when merely two years ago, bank stocks were considered safe and prudent storages of value, it must’ve seemed absurd that you can possible lose all your money. The lesson here? Past performance can give little indication of future prospects.

Changes in the macro environment; adjustment in corporate structure, ownership, management team, or overall strategy; introducing an incentive program that rewards pursuit of risky endeavors or investments: any one of these rearrangements can change the risk-reward profile of your holding. Furthermore, once the world has caught on with the upward trend of that hot sector or investment class, that golden goose has most likely already laid its golden egg, as valuation will already account for the expected increase in future profits.

While we are on the subject of past performance indicators, I also want to bring up mutual fund statistics that are tainted by survivorship bias. Ever wonder why there are few mutual fund charts showing negative returns of the industry? Because none of those failing funds still exist, and are thus taken out of the calculations. This happens when poor performing funds are liquidated or merged into existing, and better performing funds.

For example, from 1962 to 1993, a Journal of Finance study reported that a full one third of all mutual funds have disappeared. The Wall Street Journal reported that between 1982 and 1992, mutual funds reported average returns of 18.1%, but after calculating in survivorship bias, the report found that this return was whittled down to 16.3%, lower than the 17.5% return on the S&P 500 during the same period.

4) Are you a speculator or an investor?

Most people would probably define a speculator as someone that focuses on short-term profits and market trends without accounting for more fundamental business concerns. The terms trader and technical analysis are closely associated with the activities of a speculator. Whereas an investor is usually someone that has a relatively long investment horizon, assesses the fundamental soundness of a business, has lower stock turnover and a relatively diversified portfolio. Terms such as value versus growth, or passive versus enterprising are various ways of describing an investor’s preference.

The disconcerting issue arises when an investor unconsciously allows a speculative mindset to trickle into his investment activities, as this will bring unintended risks to his portfolio. Wall Street and the business reporting media fuels the speculative bubble by blatantly ignoring the fundamental state of the market and economy in their daily squawk box. The general consensus from 2006 all the way up until the 2008 downturn was that the market might be overpriced, but buy anyway, because it was going to get higher. Despite signs of slowdown, investment advisors and the media outlets pushed on with this highly irresponsible and disastrous recommendation.

Having witnesses various incarnations of this scenario, Benjamin Graham warned:

There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: 1) speculating when you think you are investing; 2) speculating seriously instead of as a pastime, when you lack proper knowledge and skills for it; and 3) risking more money in speculation than you can afford to lose.

Therefore, before you make an investment decision based on a hot tip, an upward trend, or settling on an up and coming asset class, ask if you are in fact investing or speculating, then act accordingly.

5) Know where your money is.

Do you know who your money is invested with? Good. Do you know just exactly what is happening with that investment? Probably not. It certainly does not help that many investment funds are opaque, their investment strategies not transparent nor accessible to the investors.

This might have been acceptable in the past. That was when we were still content with quarterly reports and various declarations and satisfied with vague categorization of investments. We were at ease with blurry assurances, and left others to define what a conservative or an aggressive investment strategy might be. But in light of such market turmoil and fraud, even if you trust an advisor’s assessment of your financial needs and risk tolerance, do you think they will scrutinize the ultimate destination of your money as much as you would?

I am not suggesting everyone to reclaim control of their investment portfolio and glue themselves to financial news and analysis all day. But if you really care about your investment (and you really do, if you’ve made it this far), it wouldn’t hurt to take a more active role in understanding its various components. Read about stock market history, study financial frauds and learn how to spot accounting irregularities, discern between objective analysis and hyperbole in business media reporting, listen to sources you respect, and seek out professionals with analysis that make sense to you. But most importantly, only hire people of impeccable character that you trust. But never too much.

Surely, the majority of investment advisors out there are decent, intelligent, and well-meaning folks. But that’s what everyone said about Madoff and Stanford, before they got screwed over. Sadly, we don’t know people as well as we think.

If reading about all these market complexities give you a headache and the potential idea of learning is just too burdensome, then find some low risk instruments to store your money. But with the danger of inflation always lurking around the horizon, what is low risk anyway? See, there is no easy way out with investing: you gotta work for it. Notorious B.I.G. said it best: Mo Money, Mo Problems.

Author: Jeremy Vohwinkle

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.

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